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TAX FACTS: OWNING A SECOND HOME

Written By: Alan A. Lips, C.P.A.
Published By: Aventura News
Date: January 2005

In the past few years, many South Floridians have become the proud owners of second homes.  Many buyers purchase vacation homes in resort settings ranging from Colorado and Hawaii to Sunny Isles Beach . Others purchase a townhome, condominium residence or condo-hotel unit primarily as an investment that produces rental income as well as potential appreciation.

In either case, there are some very significant tax benefits. For instance, if you itemize deductions on your federal income tax return, you can deduct the property taxes on a vacation home as well as the interest paid on your mortgage loan. Those deductions can amount to tens of thousands of dollars each year, helping to offset some of the costs of vacation ownership.

However, it is important to note that the IRS has set a limit on the amount of interest you can deduct on your personal properties. If your total mortgage indebtedness exceeds $1.1 million, you cannot deduct any interest on the loan above that amount. Let’s say you have just taken out a $500,000 mortgage at 7 percent on your primary home, which would allow you to deduct almost $35,000 in interest.  You then purchase your vacation home using a $700,000 mortgage expecting a deduction of the nearly $49,000 interest paid on that loan.  Instead, you would only be able to deduct roughly $42,000 in interest because $100,000 of that second loan – and the $7,000 interest it generates – would be over the $1.1 million cap.

Now, your tax situation changes if you purchase a second home as an investment property. If you rent a second home for more than two weeks a year, the IRS applies a different and more complex set of rules, making it particularly advisable to seek professional assistance.

In general, if you own a rental property, you must report the income you receive on your federal tax return.  But you can also deduct virtually all the expenses associated with owning and maintaining the property when used for rentals. That includes property taxes, furnishing for the unit, condominium association fees, advertising costs and maintenance and repairs.

If your second home is rented the entire year, then all these types of costs are deductible. But if you use the residence for personal use for part of the year, only those costs associated with the rentals can be deducted. For example, let's say you use in your ski lodge in Vail for one month in the summer and one month in the winter, while renting it the rest of the year. That means you could deduct 10 months worth of expenses (10/12ths of the total).

In addition, you may be able to depreciate the value of a second home, when used as a rental, producing sizable additional tax savings. (Depreciation is not available on a vacation home that is only used by the owners.)

Finally, if the total amount of the expenses and depreciation exceeds the amount of rental income, you have the added tax benefit of “passive losses” that can be applied against other types of passive income, such as investments in businesses or limited partnerships.

If you are considering buying a second home, make that decision based on your lifestyle preferences and investment goals. If buying a second home makes sense, then the tax benefits can add significant dollars to your investment.