Buying a vacation home can be an exciting step for people, but buyer beware of potential traps associated with this tricky tax situation. Determining how the property will be used is perhaps the most important factor.
Personal Use. The income tax deductions available for your second home are fairly similar to your primary residence, such as mortgage interest and property taxes that are itemized on Schedule A. However, many taxpayers are not aware of the interest deduction tax rule until they buy their second home when their home debt becomes much higher. This tax trap limits the Schedule A interest deduction based upon a loan value of $1 million for mortgage and $100,000 for home equity.
Rental Use. A vacation home held for investment purposes that you and your family do not use for personal use qualifies as rental use. This means you must fill out Schedule E and report rent as taxable income, but you may also deduct expenses associated with operating the property such as mortgage interest, repairs and maintenance, insurance and taxes, professional services, and even depreciation. One tax trap people may not understand is the limit on losses, which is $25,000 per year. The second trap to this rule is that losses for taxpayers with income greater than $100,000 are limited and taxpayers with income greater than $150,000 cannot deduct any losses at all.
Mixed Personal and Rental Use. Some people rent out their vacation home when they are not using it themselves to offset the cost. This situation is perhaps the trickiest of all because you must now keep track of how much time the property is used by you and your family for “personal use” versus by others for “rental use”. Based upon that formula, you may have to divide your expenses and have limitations on what is deductible.
When you rent out your home 14 days or less in a year, the IRS assumes its primary function is not rental use and it should not be reported on Schedule E. You are not required to report the rental income and rental expenses from this activity. The qualifying itemized deductions, including mortgage interest and property taxes may be reported as normal on Schedule A.
When you rent out your home for more than 14 days in a year, you must include all rent as taxable income. If you had a net profit from renting your home for the year, you can deduct all of your rental expenses. However, if you had a net loss from renting your home for the year, your deduction for certain rental expenses is limited. The expenditures from personal use are not deductible as rental expenses, but qualifying itemized deductions are allowed to be deducted on Schedule A.
This article only skims the surface and simplifies the tricky vacation/rental home tax rules. The applicable tax rules are complex and different taxpayers will get different tax treatments. So, make sure to talk with your tax advisor to avoid the hidden tax traps of the vacation home, whether it is for rental or personal use.
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