When you own a second home, some tax rules are similar to the ones relating to your first home. However, let’s discuss how to benefit from the tax rules once you start renting that second home.
Every year, we rent a home over the holidays in Deep Creek, Maryland. It’s a popular destination in many seasons because you can go to the lake in the summer and ski in the winter. One of the ideas we’ve tossed around is buying a vacation home there and renting it out when we aren’t using it.
Many people start renting by using services like Airbnb or VRBO, which is often the case with properties that are in popular vacation destinations. The tax rules for what you’re able to deduct will vary depending on whether the house is considered for personal use or a rental property.
If you never rent it out, it’s considered a personal residence. If you use your second home as a personal residence and you never rent it out, you get the same tax benefits as your primary residence. If you have a mortgage, you can take the same deductions for mortgage interest and property taxes. There may be limits due to income and other factors, but the fact that it’s a second home doesn’t limit you.
If you rent out your second home for 14 days or less, you do not have to report the income to the IRS. However, you are not allowed to take the expenses related to the income or claim a rental loss. It’s still considered a personal residence, and you don’t have to report that income at all. It’s sometimes known as the “Masters exception,” after the famous PGA golf tournament in Georgia, and there’s no limit to how much you can make as long as the number of days is 14 or less.
If you rent it out for more than 14 days but stay in it infrequently, then you need to check the tax rules more closely. The rule is that if you use the house for fewer than 14 days a year or 10% of the number of days you rent it out, then it’s considered a rental property. For example, if you rent it out for 100 days a year and you stay less than 10 days there, it’s a rental property. For tax purposes, it’s likely advantageous for you to have the second home considered a rental property.
If it’s a rental property, you have to report the rental income to the IRS, but you can also deduct rental expenses. These include things you would’ve been able to deduct as a personal residence, like mortgage interest and property taxes, but also other expenses, like property managers, utilities, depreciation, repairs, improvements, and insurance.
If your modified adjusted gross income (MAGI) is under $100,000, you might be eligible to claim up to $25,000 in losses from your rental property each year if you “actively participate” in your rental. Active participation requires that you work a certain number of hours on your rental activity during the year. Real estate professionals may not be subject to the passive loss limitation rules. However, losses are limited to the Passive Activity Loss (PAL) rules for non-real estate professionals. Don’t worry; any losses not taken in the year received may be carried forward until used up. Think of the losses being held as a “loss bank” that can be carried over into future years and used to offset subsequent passive income.
Finally, if you sell a primary residence, you can exclude $250,000 of capital gains ($500,000 if you are married). You can’t do this with a rental property, but you can get around this by simply making it your primary residence before you sell. That just means you used it as your main home for two out of the last five years prior to the sale.
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