If you own or are considering buying a vacation home, there are many ways to benefit from a secondary residence. The obvious advantage is using your second home for vacations and blissful retirement dreams. Or, you could rent the property through Airbnb and make some money, right? But before you let the romance carry you away, consider the tax consequences of owning a second home.
Let’s consider three tax scenarios for your secondary residence. Each one depends on the days you use it privately and the days you have it rented at fair-market value.
Do you rent your secondary residence for less than 15 days of the year and otherwise use it privately? If yes, then consider your vacation home a residential property for tax purposes. This means that rent income is tax free and there is no need to report it.
In this case, while rental expenses will also go unreported, you can still report your mortgage interest and real estate tax. In this scenario, the tax savings may not be as great. However, renting your residence short-term can provide extra cash in your pocket without any negative tax consequences.
Is your retirement still light-years away and opportunities for you to vacation are scarce? Consider turning your vacation home into an investment property. You must report all of your rental income, but you can also deduct all expenses associated with the rental. These expenses are plentiful, just check out this list:
To qualify as a rental in this scenario, there are restrictions on how much you can use the home. You must use the home privately for less than 14 days a year. Alternatively, you can use the home less than 10% of the days it is rented out at fair-market value. For more details…check out IRS Publication 527
Much like any taxable endeavor, renting your secondary property requires thorough record keeping and planning for the possible taxes. When done right, rentals are a good way to build wealth, pad your income, or act as a tax shelter.
Do you use your vacation home more than 14 days a year or more than 10% of days it’s rented? If yes, the property is treated as residential for tax reasons. You must report all rental income and can deduct some of your rental expenses as in the second case above.
However, the deductible portion of expenses must be prorated in relation to the number of days the property was rented out. For example, if you rented the vacation home at fair-market value for 182 days of the year, you would deduct half of all your rental expenses.
Also, the expenses you deduct cannot exceed the amount of rental income generated by the property. Any excess carries forward and deducts from the property’s rental income in the future.
Although this option cannot be used as a tax shelter for your other passive income, it still provides more income that is not 100% taxable.
Investment property rental is typically considered a passive activity because the income or loss is usually generated by the money you invested rather than the work that you do. Passive income adds to your active income which taxes at your regular tax rate.
However, in case of a loss you can only deduct as much as your overall passive activity income. This is where the rental property loss can be used to offset passive income from your other investments and thus provide a tax shelter.
Any unused passive activity loss carries forward for you to deduct from any passive income in the future. Passive income is subject to 3.8% of Net Investment Income Tax (NIIT) in addition to your regular tax rate.
You collected $60,000 of rental income and spent $90,000 of deductible rental expenses. You also made $30,000 in passive income from several partnerships you invested in.
Your taxable passive income would now be $0, thus eliminating the $30,000 other passive income. This means saving up to $11,880 in taxes (assuming 39.6% tax bracket) along with $1,140 Net Investment Income Tax (3.8%).
Those who meet the IRS definition of a real estate professional can have their investment property rentals treated as active income, in which case the loss can offset other active income.
If you are not a real estate pro and you manage your rental without the aid of outside property management services, you may qualify to deduct up to $25,000 of property rental loss from your non-passive income if you file as a married couple filing jointly. The possible deduction amount is $12,500 for single filers. In either case, those deduction amounts start to phase out if your adjusted gross income is over a certain threshold. These deductions aren’t available once the adjusted gross income is $150,000 for a couple filing jointly or $75,000 if single.
Another factor to consider in planning for rental property tax consequences is the sale of the property. If you generate a gain, it is taxable at a capital gains rate. That rate is currently up to 20% on the federal level. In addition to that, the Net Investment Income tax at 3.8% will apply.
One way to avoid this is to exchange one rental property for another in a 1031 Exchange. A qualifying 1031 Exchange defers the taxable gain from selling your old rental property until you sell the new one.
There is one option, requiring more planning and a discussion of if whether or not it is a viable option for you, which may shield you from the property sale’s capital gain and Net Investment Tax. That is to convert the property from a rental to a residential one.
Gain from the sale of a principal residence is subject to a capital gain exclusion of up to $500,000 if a couple filing jointly used the residence as their principal residence for at least two out of five years before the sale. Notice the two-year qualifier. In order to reduce or eliminate the capital gain from the sale of the property, you would have to convert it to principal residence at least two years before the anticipated sale. That would give you two-fifths of the total capital gain exclusion – $200,000 for a couple filing jointly. The longer you use the residence as your principal, the larger the excluded gain will be.
You and your spouse moved into your rental property 3 years before you sold it generating a $290,000 gain. As it was your principal residence for 3 of the 5 past years, your exclusion would be $300,000 (from the $500,000 total). In this scenario, the gain from the sale is eliminated entirely. Thus, you just saved up to $69,020 in taxes (20% capital gains rate plus 3.8 NIIT).
As with any major financial and tax decision, we recommend you consult with eeCPA. We provide personalized guidance with multiple scenarios, calculate tax consequences, and help you select a plan based on your situation. Give us a call at 480.596.8299 or get in touch with us now.