If you’re thinking about buying a second a home to use for vacations, rental income or a place to call home during retirement, it makes financial sense to take advantage of all the available tax breaks. The cost of ownership, after all, can be greatly reduced through tax saving deductions on mortgage interest, property taxes and other expenses.
Recent tax changes stemming from the 2017 Tax Cuts and Jobs Act (TCJA), which is now in effect until 2025, affect how much money you may be able to save. Starting in 2018, for example, married couples filing jointly can only deduct interest on up to $750,000 of qualified home loans – down from $1 million in 2017. And home equity loan interest can be deducted only if the money is used for renovations. Still, even with these changes, there are useful breaks that can help make owning a second home more affordable. Here’s a quick rundown.
Mortgage Interest Deduction
Different tax rules apply depending on whether your second home is for personal use or you plan to rent it out.
The mortgage interest deduction has long been praised as a way to make homeownership more affordable. If you use the property as a personal residence – and not a rental – you can deduct mortgage interest the same way you would on your primary home. To qualify for the deduction, the mortgage must be a secured debt on a qualified home that you own, and you must file IRS form 1040 and itemize your deductions.
For tax years 2018 to 2025, single filers and those married filing jointly can claim an itemized deduction for 100% of the interest they pay on up to $750,000 of debt secured by their first and second homes – or $375,000 if you’re married filing separately. However, if your mortgage existed before Dec. 14, 2017, you’ll continue to receive the same tax treatment as the old rules, with the $1 million debt limit.
Rental Use – The 14-Day or 10% Rule
The tax rules are quite a bit more complicated if you rent out the property. Different rules apply, depending on how many days a year you use your second home for personal versus rental use. Your situation will fall into one of three categories:
1. You rent out the property for 14 days or less. You can rent your second home to another party for up to two weeks (14 nights) each year without having to report the income to the IRS. Even if you charge $10,000 a night, you don't have to report the rental income if the home was rented out for 14 days or less. The house is still considered a personal residence, and you can deduct mortgage interest and property taxes under the standard second-home rules.
2. You rent out the property for more than 14 days and use it for fewer than 14 days or 10% of the number of days the home was rented. In this case, your property is considered a rental property and you must report rental income to the IRS. You can deduct rental expenses, including mortgage interest, property taxes, insurance premiums, fees paid to property managers, utilities and 50% of depreciation, but you need to allocate costs between personal and rental use.
It’s worth noting that fix-up days don’t count as personal use, so you can spend more than 14 days at the property if you’re doing maintenance. Plan on documenting your maintenance activities with receipts to prove you weren't just vacationing on those days.
3. You use the property for more than 14 days or 10% of the total days the home was rented. In this case, your second home is considered a personal residence. You can take the mortgage interest and property tax deductions, but you can’t claim rental losses. If a member of your family uses the property (including your spouse, siblings, parents, grandparents, children and grandchildren), those days count as personal days unless you are collecting a fair rental price.
Online mortgage tax deduction calculators, like this one from Bankrate, can help you determine how much money you may be able to save.
Home-Equity Interest Deduction
In addition to the mortgage interest deduction, you may be able to write off interest on a home-equity loan – but the rules have changed. According to the IRS, under the new tax law you can deduct interest you pay on home-equity debt only if you use the money “to buy, build or substantially improve the taxpayer’s home that secures the loan.” To qualify, the loan must be secured by your primary or second home and it can’t exceed the cost of the home.
Previously, you could take the deduction even if you used the home-equity loan to pay off credit card debt, take a vacation or even buy a second home. Under the new law, you’ll need a mortgage to buy a second home – not a home-equity loan against your primary home – if you want to claim an interest deduction. Beginning in 2018, you can deduct interest on $750,000 in home loans – but keep in mind, that’s the combined total of loans used to buy, build or improve your primary and second homes. That means if you already have $750,000 of mortgage debt, you can’t claim a deduction for any home equity interest.
Property Tax Deduction
You can deduct property taxes on your second home and, for that matter, as many properties as you own. Before the new tax law, you could deduct the entire amount of property taxes you paid on real estate you owned. Starting in 2018, however, the total of all state and local taxes that you can deduct – including property and income taxes – is limited to $10,000 per tax return, or $5,000 if married filing separately. Keep in mind that many people who buy a second home may already exceed that limit with their first home, so there may be no additional tax savings with the second home.
Selling Your Second Home
Tax laws allow you to take up to $500,000 profit (if you're married filing jointly; $250,000, if you’re single) tax-free on the sale of your primary residence. This primary-home sale exclusion doesn’t apply if you sell your second home: If you sell a house that’s not your primary residence, you may be on the hook for capital gains tax on your entire profit. If you make the second home your primary residence for at least two years before you sell it, however, you may be able to take advantage of the tax break. Special rules apply if you rented out the home: Any profit due to depreciation while you rented would be taxable.
If you’re concerned about capital gains, a good exit strategy may be a 1031 exchange, also known as a like-kind exchange or tax-deferred exchange. A 1031 exchange allows you to swap a rental or investment property for another rental or investment property of equal or greater value, on a tax-deferred basis. The advantage is that you may be able to avoid paying capital gains tax on the exchange. To qualify, the property must be considered a rental property (and not a personal residence), which means you must rent out the property for at least 15 days and use it for less than 14 days or 10% of the days the home was rented each year.
The Bottom Line
If it's financially feasible, owning a second home can be an excellent investment for vacation or rental purposes, or to use as a primary home during retirement. Because owning any home carries a significant financial burden – from mortgage and taxes, to maintenance and repairs – it’s in your best interest to learn the tax implications of second-home ownership. Since tax laws are complicated and change periodically, it’s advisable to consult with a qualified real-estate tax specialist who can explain relevant tax implications and laws and help you determine the most favorable ownership strategy for your situation.