Questions you’re asking: What is considered a second home for tax purposes?

Maybe you’re already picturing it: a seaside home away from home. And maybe you’re also picturing the income it could generate as a vacation rental when you’re not using it. But before you sign on the dotted line to buy it, you’ll need to know what is considered a second home for tax purposes. Here are a few basics to be aware of.

Tax exposure depends on how much time you spend there

For the IRS to consider a second home a personal residence for the tax year, you need to use the home for more than 14 days or 10% of the days that you rent it out, whichever is greater. So if you rented the house for 40 weeks (280 days), you would need to use the home for more than 28 days.

Assuming your second home is considered a personal residence:

• You don’t need to report rental income to the IRS if you rent the home for fewer than 15 days per year. The usual mortgage rules apply. You can’t deduct any rental expenses, such as advertising or cleaning costs.
• In most cases, having a second home categorized as a personal residence means you may be able to deduct some or all of the interest. Interest on your first and second home mortgages up to a combined value of $750,000 (or $1 million if your mortgage started on or before December 15, 2017) may be deductible assuming each mortgage is secured by the home.

Assuming your second home is considered a rental/investment property:

• You must report rental income to the IRS if you rent your home for more than 15 days per year and your personal use of the property does not exceed 14 days per year or 10% of the number of days that the home was rented.
• In this case, you can deduct expenses for the rental, including maintenance and utilities.

 What about property taxes?

• If you own two houses, both of which are strictly for personal use, you owe two sets of property taxes. Currently, under the Tax Cuts and Jobs Act of 2017, there’s a $10,000 deduction limit ($5,000 if married filing separately) for state and local taxes paid, which includes property taxes. This $10,000 maximum could limit your ability to take a deduction for property taxes on your first and second homes.
• If the second home is considered a rental/investment property, you may have the ability to deduct all or a portion of the property tax without the above $10,000 limitation.

What about capital gains?

For owners of multiple residences, the tax consequences of a sale of one or more of those residences is often an important consideration.

Any gain from the sale of a residence is typically taxed using either long-term capital gains rates (for homes owned longer than a year) or ordinary income rates (for homes owned a year or less). With top federal marginal rates of 20% for capital gains, 37% for ordinary income, and the potential addition of net investment income taxes and/or state-specific income taxes, a residence sold for a gain could yield a hefty tax bill. But for primary residences — that is, a home that you have lived in for more than six months for at least two of the previous five years — the internal revenue code provides an exclusion of $250,000 of gain for a single taxpayer or $500,000 for a married couple.

As an example, if a married couple has a basis of $1,000,000, in their primary residence and sells it for $1,400,000, their $400,000 gain should be covered by this exclusion. But if that house instead sold for $1,600,000, they would likely owe capital gains taxes on $100,000 of their gain (the amount in excess of their $500,000 exclusion).

While this primary residence exclusion can be used multiple times over the course of a taxpayer’s life, it can only be used once within any two-year period. For any residence other than a primary residence, this exclusion does not apply.

The sale of a non-primary personal residence or investment residence is treated as any other capital asset and will generally be subject to capital gains or ordinary income taxes on any realized gain without the benefit of the primary residence exclusion.

Because the calculation of the gain on the sale of a primary residence can be complicated, and because other exclusions, exemptions, or deferral mechanisms may be available for the sale of non-primary residences in some circumstances (for example, 1031 exchanges, loss deductions, etc.), it is imperative that you consult with your financial, tax, and legal advisors as part of the process of selling any residence.

Note: These rules are complicated and there may be other tax implications depending on your specific situation and the location of your home. A financial or tax advisor can help you explore the details.