The American Dream has undergone a fair amount of change over the last 50 years. Sometime after cars and televisions became a regular part of even the lowest income earner's life, it became fashionable to buy a second home - a vacation home. These are the cottages on the lakeside, the cabins in the mountains and the huts on the beach that all sit empty 90% of the year while their owners are banking time for the next vacation - and footing the bill for the mortgage and property taxes.

There is, of course, an alternative to letting your cottage molder during the down time. You can rent it out to other people looking to enjoy some time away from work. This article will look at some of the issues that surround renting out a second home.

Tutorial: Exploring Real Estate Investments

Buying a Second Home
Keeping a primary residence is an enormous financial decision. Keeping a second home is a step up in magnitude because a second home has all the costs (often more) of your first home without the easy write-offs from the IRS. By and large, second homes are often a terrible financial burden, rather than a good investment. One of the litmus tests of whether you should have a second property is whether you can handle an all-cash purchase. This will help you to avoid passive losses because your mortgage payments will be non-existent. (To find out more about mortgages, see How Will Your Mortgage Rate?, Understanding the Mortgage Payment Structure and Paying Off Your Mortgage.)

If you are set on getting a vacation home but don't have the capital for an all-cash purchase, do not take a second mortgage on your home. The IRS has closed the loophole whereby a person could use a second mortgage to purchase a separate investment property while still deducting his or her mortgage from taxes. If you take a mortgage on your primary residence to buy a second home, you will not be allowed to deduct the payments as personal mortgage interest. If you intend to borrow for a second home, you will have to take out another mortgage that allows for tax deductible interest. Again, it is probably best to hold off until you have enough capital to buy the property outright.

As It Stands
Current tax rules surrounding second homes, vacation homes and investment-class second homes have changed more frequently than those of primary residences. As of 2010, if you currently own a second home for personal use, you are allowed to rent it, or your primary residence for that matter, to another party for up to two weeks (14 nights) without reporting any of the income. On the flip side, a second home is considered an investment property if you spend less than two weeks in it and then attempt to rent it the rest of the time. It is important to remember that, with the advent of resorts and such, the demand for a cabin in the woods may only come at the peak times - the same period of time you would probably want to use the property yourself. (To learn more about being a landlord, see Tax Deductions For Rental Property Owners, Investing In Real Estate and Tips For The Prospective Landlord.)

The IRS on Vacation-Home Investment
Although taxes for investment properties have been traditionally softer than for other types of investing, second homes seem to be a gray spot for the IRS. All rental losses are "passive losses" or "hobby losses"; and, these can only be used against - written-off against - income from other passive activities like other rentals, a private partnership you don't help operate or an S-corporation. Passive losses that you can't use are carried forward until you sell the vacation home. When you sell the property, the past losses can be used to offset any gains and, if you have more passive loss write-offs afterward, you can claim them against regular income.

You can, however, deduct up to $25,000 a year, if:

  • Your adjusted gross income is less than $100,000 or
  • You actively participate in the management of the property.

This tax break vanishes at $150,000 adjusted gross income (AGI). If you are between $100,000 and $150,000 you qualify for half the deduction. This seems foolish, as most of the people who can afford to buy a second home will have an AGI far above these numbers. Still, the real challenge is in the second condition. You can use the yearly deduction if you or your spouse want to become a qualified real estate professional and actively manage the property that is posting the passive losses. Be warned, however, the IRS is not likely to believe that you hold a full-time job and moonlight as a property manager. You will need a detailed journal on why, when, where and what you are doing as a property manager in order to prove your case.

Selling a Vacation Home
Properties in popular vacation areas usually tend to see higher-than-average appreciation, so there may be a time when you want to cash-in and find a new place to stay. When selling a vacation home, the length of time you have held it affects your capital gains tax. If you sell before a year has passed, you will be subject to the short-term capital gains rate. If you sell after a year, your federal tax will be calculated at the long-term capital gains rate. (To read more about capital gains tax, see A Long-Term Mindset Meets Dreaded Capital-Gains Tax, Capital Gains Tax Cuts For Middle Income Investors and To Sell Or Not To Sell.)

You can, however, do a bit of a dodge if you are willing to completely relocate. If you sell your primary residence with the $250,000 per person tax-free, and then move into the vacation home and declare it your new primary residence, you will be able to use the $250,000 ($500,000 for couples) exemption again - providing you live there for two years. Unfortunately, this strategy is often only practical for the self-employed or retired. There also other restrictions on the use of the capital gains exclusion for vacation homes that have been converted to a primary residence. (For more insight, see Is it true that you can sell your home and not pay capital gains tax?)

Tips for the Second Homeowner
If you own a second home for the purpose of renting it, and you have an AGI under $150,000, then get in there and start managing. This means that you won't be able to use an agent to find tenants and you will be arranging repairs personally, but it will give you passive losses to write off. Or, if active management doesn't appeal to you or your AGI is too high, you can spend more time at the cabin and turn it into a mixed-use property rather than an investment property. This means that the taxes change with the change of designation - mainly that you can't use passive losses, but you will be able to claim a percentage of the mortgage interest and property taxes as deductions against your income tax.

Because owning a vacation home is more a compulsion than a financial decision, turning the property into a profitable rental tends to be an uphill battle. Before you jump into being a vacation-home landlord, take a good look at how your taxes will be affected. Most people who own second homes would be better served by getting them classified as a mixed-use property for tax purposes and renting them out for only the tax-free 14 nights in a given year. The people who do become second-home landlords, however, usually are driven by the same compulsion that forced them to buy the place in the first place. If you are one of those people, your best course of action is to get actively involved in managing your own property.

Related Articles
  1. Home & Auto

    Beach House Investing: Best Beach Towns in North Carolina

    Find out about some of the most popular coastal cities in North Carolina for individuals considering beach house investing in the state.
  2. Personal Finance

    The 6 Most Expensive Apartments in New York City

    A look into the high, high, high end of New York City real estate.
  3. Personal Finance

    3 Castles That Cost Less Than a NYC Apartment

    Did you know you can rent an entire château, and that it might cost less than your New York pad?
  4. Investing

    5 Ways to Reduce Your Taxes After a Windfall Gain

    Windfall income is a welcome padding to any bank account, but plan for the government's share before you start spending.
  5. Retirement

    How Are 401(k) Withdrawals Taxed for Nonresidents?

    As a U.S. nonresident, deciding what to do with your 401(k) after you return home comes down to which tax penalties, if any, you're willing to incur.
  6. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  7. Taxes

    Here's How to Deduct Your Stock Losses From Your Tax Bill

    Learn the proper procedure for deducting stock investing losses, and get some tips on how to strategically take losses to lower your income tax bill.
  8. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  9. Mutual Funds & ETFs

    Top 4 Global Real Estate Mutual Funds

    Read about four of the best global real estate mutual funds, which invest in the securities of real estate companies or real estate investment trusts (REITs).
  10. Stock Analysis

    3 Solar Stocks to Add to Your Portfolio

    Understand the growth and challenges of the renewable energy market and its success in 2015. Learn about the top three energy stocks to add to a portfolio.
  1. Why is the Cayman Islands considered a tax haven?

    The Cayman Islands is one of the most well-known tax havens in the world. Unlike most countries, the Cayman Islands does ... Read Full Answer >>
  2. Why is Luxembourg considered a tax haven?

    Luxembourg has been the tax haven of choice for many corporations and mega-rich individuals around the world since the 197 ... Read Full Answer >>
  3. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  4. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  5. Why is Panama considered a tax haven?

    The Republic of Panama is considered one of the most well-established pure tax havens in the Caribbean due to extensive legislation ... Read Full Answer >>
  6. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!