Second Homes
Whether for business or pleasure, many people are buying a second home. Make sure you understand the ins and outs of second-home ownership.
By Phil Dyer, CFP

Thinking about buying a second home as a vacation or investment property? A National Association of Realtors report indicates nearly 40 percent of all home sales in 2005 were second homes. What’s the tax impact?

Expenses associated with vacation-home ownership, such as mortgage interest and property taxes, generally are treated the same as expenses with a primary residence.

Mortgage interest on first and second properties is deductible, up to a total of $1 million in acquisition costs. Mortgage interest on third and subsequent properties is considered nondeductible personal interest. Property taxes paid on all properties, not just first and second homes, also is deductible — as is up to $100,000 of home equity loan interest on first and second properties.

If you rent out a vacation home for up to 14 days throughout the year, you do not need to report rental income, but you cannot deduct any associated rental expenses.

One potential drawback: The gain on the sale of a vacation home does not qualify for the capital gains exclusion ($500,000 for married couples, filing jointly; $250,000 for single filers) that a primary residence does. You may avoid this by selling your primary residence, relocating to the vacation property, and converting it to your primary residence to meet the two-out-of-five-year “use rule” before you sell it.

Second homes purchased for investment typically provide more tax benefits than vacation homes, but you sacrifice the right to use the property more than a couple of weeks each year. Provided your personal use of the property is no more than 14 days, or 10 percent of the number of days rented at fair rental value, expenses related to the rental are deductible on Form 1040, Schedule E.

These expenses may include mortgage interest, property taxes, depreciation, property management fees, repairs, cleaning, landscaping, and even two property inspections a year. If these expenses are greater than your rental income from the property — which is often the case — you may be able to deduct up to $25,000 of passive investment losses against regular income, making the rental property an excellent way to shelter other income.

To qualify for passive loss rules, you or your spouse must “actively participate” in the rental activity. This involves owning at least 10 percent of the property and being substantially involved in property management (a limited partner cannot meet the active participation test). The $25,000 passive loss is available for taxpayers with an adjusted gross income (AGI) of $100,000 or less and phases out between $100,000 and $150,000 AGI. Consult your tax advisor before purchasing a second home.