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.

Conclusion
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. Economics

    What Happened at the Fiscal Cliff?

    The fiscal cliff refers to a scenario on December 31, 2012, in which the Bush-era tax cuts were set to expire.
  2. Home & Auto

    Millennials Guide: How To Read a Lease

    Everything you need to know before you rent a home.
  3. Investing

    Why You Should Buy In Gentrifying Neighborhoods 

    Living in a gentrifying area has many benefits, not least of which is a property's investment potential.
  4. Term

    Understanding Total Returns

    Total return measures the rate of return earned from an investment over a period of time.
  5. Savings

    Best Places To Exchange Currency In Miami

    Miami may be a 24-hour party, but it takes plenty of cash to get in the groove. Here's where to exchange foreign currency before you head for South Beach.
  6. Mutual Funds & ETFs

    Comparing ETFs Vs. Mutual Funds For Tax Efficiency

    Explore a comparison of mutual funds and exchange-traded funds, or ETFs, and learn what makes ETFs a significantly more tax-efficient investment.
  7. Mutual Funds & ETFs

    Top 5 Precious Metals Mutual Funds

    Obtain information and analysis of some of the top-rated and most popular mutual funds that offer investors exposure to the precious metals industry.
  8. Investing

    Why Las Vegas Hotels Charge Resort Fees

    One of the easiest ways that hotels send their guests home with thinner wallets is by means of drip pricing, the act of charging additional mandatory fees for even the cheapest of hotel rooms.
  9. Technical Indicators

    Use Market Volume Data to Determine a Bottom

    Market bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls.
  10. Investing Basics

    Understanding How Dividends Are Taxed

    Learn how dividends are taxed by the IRS, and understand the different types of dividend income as well as the capital gains tax rates.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has ...
  4. Turnkey Property

    A fully renovated home or apartment building that an investor ...
  5. Wealth Management

    A high-level professional service that combines financial/investment ...
  6. Enterprise Investment Scheme (EIS)

    A UK program that helps smaller, riskier companies to raise capital ...
RELATED FAQS
  1. Are dividends considered passive or ordinary income?

    Despite the fact that earning dividends requires no active participation on the part of the shareholder, they do not meet ... Read Full Answer >>
  2. Is dividend income taxable?

    Dividend income is taxable but it is taxed in different ways depending on whether the dividends are qualified or nonqualified. ... Read Full Answer >>
  3. Can I use my IRA savings to start my own savings?

    While there is no legal reason why you cannot withdraw funds from your IRA to start a traditional savings account, it is ... Read Full Answer >>
  4. Are spousal Social Security benefits taxable?

    Your spousal Social Security benefits may be taxable, depending on your total household income for the year. About one-third ... Read Full Answer >>
  5. How are non-qualified variable annuities taxed?

    Non-qualified variable annuities are tax-deferred investment vehicles with a unique tax structure. After-tax money is deposited ... Read Full Answer >>
  6. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... 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!