Maximize Investments Utilizing Tax Law
Second homes can provide owners with a variety of income tax benefits such as:
- Deductions for real estate taxes;
- Deductions for mortgage interest;
- Deductions for rental expenses;
- Exclusion of rental income in certain circumstances;
- Possibility of tax-free, like-kind exchanges;
- Conversion to primary residence and exclusion of gain upon sale.
Income Tax Deductions
Homeowners can deduct real estate taxes on both their primary residence and second home.
The Internal Revenue Code also permits a deduction for mortgage interest paid on both a primary and secondary residence. However, the mortgage interest on a second home is only deductible if (i) the second home is a “qualified residence” and (ii) the mortgages on the primary and secondary residences do not exceed $1,100,000 ($550,000 if married filing separately), which includes $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness.
A “qualified residence”, in the case of a second home, is one that is not rented out at any time during a calendar year, or that is used by the taxpayer for a number of days exceeding the greater of (i) 14 days or (ii) 10% of the number of days that it is rented out at a fair rental value. If the home is not a “qualified residence,” a portion of the mortgage interest may still be deducted as a rental expense, which is discussed below.
Minimal Rental of Second Home
– Income Tax Rules
If the second home is rented for less than 15 days in a calendar year (i) the rent received is tax-free and (ii) no deductions attributable to such rental are allowable. This is sometimes referred to as the “Masters rule” in reference to those individuals living near Augusta, Georgia who rent their homes solely during the week of the Masters Golf Tournament.
Rental of Second Home for More than a Minimal Period
–Income Tax Rules
If a second home is rented for more than 14 days, the homeowners must report all rental income. However, the rental income can generally be reduced by real estate taxes and mortgage interest as discussed above, and a portion of the following rental expenses:
- Insurance premiums;
- Property management expenses; and
As a general rule, deductible expenses may not exceed the gross rental income received on the second home. However, if the second home is not a “qualified residence”, then certain rules under the Internal Revenue Code may permit the deduction of expenses that exceed the gross rental income.
Tax-Free Exchange of a Second Home
The homeowner and spouse can exclude up to $500,000 of gain on the sale of a primary residence. This exclusion does not apply to a second home. If the second home is held for “investment purposes” (and not for personal use as determined under Section 1031 of the Internal Revenue Code), then under Section 1031, homeowners may be able to defer tax on the gain resulting from the “exchange” of the second home by acquiring another second home or certain other real estate which qualifies as “like-kind”. (Based on certain circumstances, the use of a second home can be converted from “personal use” to being held for “investment” and be eligible for a “tax-free, like kind” exchange.) The rules relating to a “tax-free, like-kind” exchange are complex and beyond the scope of this article.
The benefit of a “tax-free, like-kind” exchange is best shown by example. Assume Bill and Mary (whose primary residence is in Mission Hills, Kansas) own a second home in Florida that has a $200,000 basis, is held for “investment purposes”, and is now worth $400,000. Bill and Mary decide they would rather own a second home at the Lake of the Ozarks. If Bill and Mary sell their second home in Florida for $400,000, they will incur a $200,000 taxable gain. However, if Bill and Mary intend to hold the home in the Ozarks for “investment purposes”, they can use the “tax-free, like-kind” exchange rules to defer the recognition of gain and payment of tax upon the exchange of their second home in Florida; provided the second home in the Ozarks has a fair market value of at least $400,000.
Conversion of a Second Home into a Primary Residence
In order for the $500,000 exclusion on the sale of a primary residence to apply, the homeowners must live in the primary residence for at least two of the five years prior to the sale. Under certain circumstances, this exclusion may be available in part for a second home which has been converted to a primary residence.
Assume, in the case of the previous example, that instead of selling their second home in Florida, Bill and Mary decide to retire to Florida. Upon the sale of their primary residence in Mission Hills, Kansas, they can exclude from their taxes up to $500,000 of the gain. If, after two years, Bill and Mary decide they would rather be close to their grandkids and move back to Mission Hills, Kansas, their Florida home now qualifies as their primary residence. Upon the sale of their home in Florida, they can exclude that portion of the gain on the home that is attributable to the two years in which the Florida home was their primary residence. Thus, Bill and Mary are able to shelter the gain on the sale of their Mission Hills, Kansas, home and are able to shelter a portion of their gain on their Florida home.