Do you dream of a beach house to escape to for summer vacation, or a second home in Florida in which to pass the bitterly cold winters? Tax reform just made owning a second home more costly, so if you are thinking of buying a vacation home, you may want to think again or consider becoming a landlord.
Tax Reform lowered the mortgage interest deduction to $750,000 from $1 million. That cap applies to all homes purchased after December 15, 2017. If you already have a $750,000 mortgage and plan to buy a second home next year, you will not be able to deduct the interest on that second loan. Moreover, the new tax law caps deductions for property taxes and any state and local income taxes at $10,000.
Contrary to popular opinion, many second home buyers are not super rich. According to the National Association of Realtors, almost 75% use mortgage financing. Buyers should keep in mind that tax reform legislation may drive down the price of some real estate, especially in pricey coastal markets, creating uncertainty that an expensive real estate investment will appreciate enough to make a purchase worthwhile.
For most people who buy second homes, combining the first and second mortgages will far exceed the cap of $750,000 in mortgage interest, so they will lose the ability to offset interest on their second homes. Many second home buyers traditionally used a home equity loan to finance the purchase of a vacation house and can still consider doing so if the loan is secured by the vacation home (see #2 below). The IRS advises that despite newly-enacted restrictions on home mortgages, taxpayers can still deduct interest on a home equity loan, home equity line of credit or second mortgage (regardless of how the loan is labeled) as long as used to buy, build or substantially improve the taxpayer’s home that secures the loan. The Tax Cuts and Jobs Act of 2017 suspends till 2026 the deduction for interest paid on home equity loans and lines of credit, if used to pay personal living expenses, such as credit card debts, or for other purposes. To illustrate we have three examples:
Example 1: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a primary residence with a fair market value of $800,000. In February 2018, the taxpayer takes out a $250,000 home equity loan for an addition. Both loans are secured by the main home and the total does not exceed the cost of the home. Because the total amount of both loans does not exceed $750,000, all of the interest paid on the loans is deductible. BUT, if the taxpayer used the home equity loan for personal expenses, or to pay off student loans or credit cards, then the interest on the home equity loan would not be deductible.
Example 2: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a primary residence. The loan is secured by the main home. In February 2018, the taxpayer takes out a $250,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages does not exceed $750,000, all of the interest paid on both mortgages is deductible. BUT, if the taxpayer took out a $250,000 home equity loan on the main home to purchase the vacation home, then the interest on the home equity loan would not be deductible.
Example 3: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a primary residence. The loan is secured by the main home. In February 2018, the taxpayer takes out a $500,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages is $1,000,000 and exceeds $750,000, not all of the interest paid on the mortgages is deductible, just a percentage.
Of course vacation home buyers should not base their decision on whether to purchase a second home solely on taxes. If you can afford the mortgage and the maintenance, plus the other miscellaneous expenses great – otherwise even a stay at a swanky hotel while you are on vacation might make more sense! But if you decide to move forward consider this: The one-two wallop of a lower cap on deductible mortgage interest and a new cap on the deduction of property taxes is going to hit your wallet hard. Get ready to rent out your new vacation home. With tax reform, it no longer makes financial sense to leave your vacation home empty if it could be rented out when not in use.
Believe it or not, transforming your dream vacation getaway into a rental income producer has never been simpler — or more profitable. Technology has made it easy for guests to find the right vacation rental. But you must understand the general rules of use when it comes to renting out your vacation home. Even when listing with services such as Airbnb, HomeAway, VRBO, or FlipKey, you can keep your income taxes to a minimum by being educated on the IRS rules.
The tax rules are different for a rental property versus a vacation property. And mixing both could unwittingly put you in violation of IRS regulations. Watch out for IRS rules that define the property based on how you use it, it will affect what expenses you can deduct. It is considered your residence if you use it for personal purposes during the tax year for more than the greater of:
2. 10% of the total days you rent it to others at a fair rental price.
This means if you use the property for more than 14 days of the year, it is considered a personal residence rather than a rental property. Owners can still use their vacation home for personal use and rent it out, but you must document the usage and remember that limitations may apply to the rental expenses you can deduct. You can deduct rental expenses up to the level of rental income. But you can’t deduct losses.
A special rule applies if you rent your residence for less than 15 days. In this case you are NOT considered a landlord – you don’t have to report any of the rental income but you don’t get to deduct any rental expenses. There is no limit to how much you can charge. You can still claim the usual homeowner deductions for mortgage interest, real-estate taxes, and casualty losses.
If you rent your home out for more than 14 days, you become a landlord and must report the rental income. If you receive rental income, you may deduct certain expenses including mortgage interest, real estate taxes, casualty losses, maintenance, utilities, insurance, and depreciation. This will reduce the amount of rental income that’s subject to tax. Costs must be allocated between personal use time and rental time. If you’re renting to make a profit and don’t use the dwelling unit as a residence, then your deductible rental expenses may be more than your gross rental income. Your rental losses, however, generally will be limited by the “at-risk” rules and/or the passive activity loss rules.
Other items of importance:
2. Tax reform allows a special 20% tax deduction for so-called pass-through businesses. For most of the people who rent their vacation property, income from that activity is “passed through” to the owners’ tax return. Depending on their income, landlords may be able to deduct up to 20% of their net rental income, but thresholds and exceptions apply – check with your Fuoco Group professional about qualifications for the 20% break.
3. You can make the rental property a private residence again by moving back in before you sold it so the sale would not be subject to more capital gains tax as a business, if it appreciated in value. You can avoid paying capital gains on your home sale if you’ve lived in the house for at least two of the five years prior to selling.
4. While some dream of living on the water…others have made that dream come true! Now the IRS is recognizing certain boats as a “second home,” and that can spell tax savings. Recreational vessels with a sleeping berth, cooking, and toilet facilities will be treated equally as second homes (like some recreational vehicles) and may qualify for some sales tax and mortgage interest deductions when filing (in 2019) a 2018 federal income tax return. If you are interested in a recent Fuoco Group tax article related to tapping the tax advantages of boat ownership, please click here: http://www.fuoco.com/resources/tax-alerts/289-keeping-your-yacht-afloat-turning-a-hobby-into-a-profit.
Contact Us – Be sure to contact your Fuoco Group advisor before investing in that vacation home of your dreams. We can help you navigate the tangled web of real estate ownership, tax forms, and interpreting IRS guidance and the new parameters of Tax Reform. Good tax planning makes a difference in your return on any real estate investment, especially a second home, vacation or rental property. There are complex rules relating to nexus, income, depreciation, deductions, record keeping, passive losses, etc. Do not fail to take advantage of all the tax deductions available for owners of rental property. Tax benefits can make the difference between earning a profit or losing money in rental real estate. Know your goals – is it to eventually retire there, generate income in the meantime, or sell the property at a premium. You have questions? We have answers!
