If you ask a real estate agent, a mortgage lender, and a tax attorney to define a second home, you'll probably get three different answers.
There's no specific definition of a second home, other than a property that isn't your primary home that you live in some of the time. But when it comes to the actual number of days you occupy the property and whether you rent it out when you aren't using it, there's no set-in-stone definition.
The IRS has a clear distinction between second homes and investment properties, and it's important to know it when you do your taxes. Here's how to tell how the IRS categorizes your property and the tax differences that come with it.
Second home vs. investment property: What's the difference?
The simple answer is that a second home is a property other than your primary home that you intend to live in some of the time. An investment property is a home that you'll never live in.
It's important to clarify that the term "second home" is somewhat misleading. You can have more than one home that's considered a second home as long as it meets the appropriate definition.
Having said that, the precise definition of a second home depends on who you ask.
How lenders define a second home
Lenders tend to have their own rules on which purchases qualify for second home financing. Some let you rent the property for a certain amount of time, while others won't finance a second home if you plan to rent it at all.
Generally speaking, it's easier and cheaper to finance a second home than an investment property. So lenders take steps to ensure that the property in question is actually going to be someone's second home -- not just an investment.
How the IRS defines a second home
The IRS has its own definition of a second home, and it's important for tax purposes. You can consider a property a second home if you meet one of two conditions:
- You use the home at least 14 days each year.
- You use the home at least 10% of the days that you rent it out.
It's important to note that you have to satisfy the condition that results in the greater number of days.
For example, if you rent your property out for 200 days in a year, you need to personally use it for at least 20 days for it to be considered a second home. If you use it less than that, it's an investment property for tax purposes.
This doesn't mean you need to use it for any consecutive number of days. In our example, you can meet the 20-day requirement with four five-day stays, two 10-day stays, or any other combination.
Technically speaking, this is how the IRS defines any residence. But it generally doesn't come into play with primary residences.
Second homes get the mortgage interest deduction
It’s well-known that mortgage interest is deductible on primary residences if you itemize deductions. However, many people don’t realize that the mortgage interest deduction can apply to second homes, as well.
The IRS currently lets you deduct the interest paid on as much as $750,000 in qualified personal residence debt. This can mean a primary residence or a secondary residence. It could also apply to home equity debt if the money you borrowed was used to substantially improve a primary or secondary home.
This deduction isn't available for investment property mortgage interest. It can be deducted as a business expense to lower your rental income, however.
One caveat is that the mortgage interest deduction is an itemized tax deduction. You can’t use it if you claim the standard deduction.
For the 2019 tax year, the standard deduction is $12,200 for single taxpayers and $24,400 for married taxpayers filing joint returns. Unless your itemizable deductions, including mortgage interest, are greater than your corresponding standard deduction, you won’t benefit from deducting mortgage interest on a second home.
Rental properties get a depreciation deduction
Investment properties never qualify for the mortgage interest deduction. However, there's another tax benefit known as depreciation that investment property owners can take advantage of. A few second-home owners can use it, too.
Here's how it works. When a business buys an asset that has a finite useful life span, that business can deduct the cost of the asset over a certain number of years. For example, a $1,000 asset with a useful life of five years could be deducted at the rate of $200 per year until the entire amount had been written off.
This also applies when businesses buy real estate. The IRS lets investors depreciate the cost of their investment properties over a period of 27.5 years (39 for commercial properties). If you buy an investment property for $200,000, you'll get a $7,273 annual depreciation deduction. You can use this to offset your rental income.
This can result in big tax savings, but there's a caveat. If you sell your investment property, you'll have to pay a tax known as depreciation recapture. In short, all the depreciation deductions you've taken are considered taxable income when you sell. Investors can avoid this by using a 1031 exchange to buy another property, but you may have to repay your depreciation deductions eventually.
The depreciation deduction can apply to second homes as well, but only for the proportion of the days the property was used as a rental. For example, if you rent your home for 70 days this year and use it for 30 days, you can only take 70% of a normal full-year depreciation deduction. The same depreciation recapture tax applies when you eventually sell the home.
Taxes on rental income
Whether your home is classified as a second home or an investment property, rental income is taxable. The good news is that there are a bunch of expenses you can deduct, including (but not limited to) the following:
- Interest you paid on a mortgage, but not if you used the mortgage interest deduction I already mentioned. As a general rule, you can never take two tax deductions for the same expense.
- Property taxes.
- Operating expenses such as property management fees, pest control, and landlord-paid utilities.
- The cost of any repairs you made.
One major difference is that while you can deduct maintenance and other operating expenses from all rental property income, you can't deduct losses with a second home.
On the other hand, you can deduct rental losses on an investment property. If you take in $10,000 in rental income and spend $12,000 on maintenance this year, you may be able to deduct that $2,000 loss against your other income. You can't do this if it's a second home -- you would simply report your taxable rental income as zero.
If a property is both for personal use and renting, the IRS requires that you divide the expenses when offsetting your rental income. This applies whether the property is a second home or an investment property.
If you had $5,000 in maintenance expenses for a property that was rented for 80% of the total number of days it was used, you can only use $4,000 of that amount to lower your taxable rental income.
Finally, here's one more important thing to keep in mind. If you rent a home out for fewer than 15 days in a year, the IRS doesn't require you to report any of your rental income. This applies to primary and secondary homes as well as investment properties.
So, if you have a second home that you generally use for personal use, you can rent it out for as many as 14 days to generate some tax-free income.
Property tax deductions
For both second homes and investment properties, the annual real estate property taxes you pay can be deductible. However, the method by which you deduct them may differ.
For a second home, you can deduct property taxes on your tax return as part of the state and local taxes deduction (also known as the SALT deduction). Unfortunately, this is capped at a total deduction of $10,000 per year. That includes property taxes you pay on your primary residence and any state and local income taxes you pay. Many taxpayers can't use this.
However, you can deduct the proportion of the property taxes that represent the time it was rented if you meet two conditions:
- You can't deduct property taxes on a second home as part of the SALT deduction.
- You have taxable rental income from the property.
If you paid $3,000 in property tax and the home was rented two-thirds of the time, you could use $2,000 as an expense to reduce your rental income.
For an investment property, your entire property tax bill is deductible against your rental income as a business expense.
Which is the more tax-advantaged type of property?
There’s no one-size-fits-all answer to this question -- it depends on your personal situation. For example, if you can take advantage of the mortgage interest deduction, a second home becomes a more tax-advantaged form of real estate than if you can’t.
The bottom line is that there are tax advantages that apply to second homes, some that apply to investment properties, and some that apply to both.
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