Owning any type of real estate involves an array of financial considerations and tax implications, but there are special issues that relate to properties used as second homes or rentals. It’s important to keep this in mind if you are thinking about buying another property, either as a second residence or an investment.
Here’s a quick rundown of the benefits and drawbacks of a second home or rental property, from a tax perspective.
- Expenses and costs related to maintaining or improving a rental property are generally tax-deductible.
- Mortgage interest is tax-deductible, up to a certain point, for a second home.
- Real estate taxes paid on the property are also typically deductible.
- You must report rent you receive as income, which is taxable.
- Some of the tax issues involved can be complicated, and will likely require the guidance of a tax professional.
A second home generally offers the same tax advantages and deductions as your first home, as long as you use it as a personal residence.
The Tax Cuts and Jobs Act—the tax reform package passed in December 2017—lowered the maximum for the mortgage interest deduction. Taxpayers who buy (or bought) a property after that point can deduct interest for mortgage loans of up to $750,000 (or $375,000 for married filing separately). This applies for both first and second homes, as long as you are using the house as your own residence.
You can also deduct real estate taxes paid on the property. (There’s a limit of $10,000 for this deduction, or $5,000 if married filing separately.)
Of course, the deductions for mortgage interest and real estate taxes are only relevant if you itemize your deductions. If you opt to take the standard deduction, these deductions wouldn’t apply.
What makes a rental home a rental home? If you have a property that you use as a second home part of the time, but also use as a rental sometimes, there’s a specific IRS guideline you need to consider: If you rent the home for 14 days or less each year, the IRS does not consider it a rental. The property is still considered a personal residence, so you don’t have to report the rental income and can take the same deductions you would for your first home.
However, if you rent the home out for more than two weeks a year, things get a bit more tricky. If you use the home for yourself fewer than 14 days—or less than 10 percent of the amount of time it is rented, whichever is longer—it is considered a rental property, and the normal tax rules regarding a rental property would apply.
Owners of rental properties have options to minimize their tax obligations or offset the costs to maintain the property. You can deduct the amount you pay in local and state real estate taxes on the rental property. The same limits for this deduction apply as for your personal residence.
Rental income must be reported on your taxes—but the expenses related to that property can be deducted from that income, which helps lower the taxable amount. For a rental property, you are allowed to deduct a variety of “operating expenses.” This includes costs related to maintenance, insurance, utilities, advertising, and some repairs or supplies.
You may also be able to take advantage of depreciation to help lower your tax obligation on a rental property. This means you can deduct a portion of the price for the building (not land), as well as the cost of major improvements or renovation projects, each year for a certain number of years. Calculating the exact amount you can deduct can be challenging, so this is something you will probably want to leave to your accountant or tax adviser.
Lastly, up to $25,000 in losses on a rental property may be deductible. This rule has a lot of conditions and criteria that must be met, though. You must be actively involved in maintaining the property, so this mainly applies to small-scale property owners as opposed to investors with many properties. And the ability to deduct losses only applies if your Adjusted Gross Income is under a certain amount. (This is where you would definitely want to enlist the help of your tax adviser.)
Those are the basics of paying taxes on rental homes and second homes, but here’s a necessary disclaimer: As with many things tax-related, the issues related to second homes or rental properties can be complicated, and rules change frequently. This information should not be considered financial advice, and you should always consult a professional for help with financial or tax matters.