Tax Implications of Owning a Vacation Home

Tax Implications of Owning a Vacation Home: What Everyone Ought To Know

Ah… the allure of owning a vacation home. You might start dreaming, “What if we owned the property and could escape the stresses of daily life more often?” Well just like most things the answer can be debated in terms of time and money.

Let’s first look at the time aspect of owning a second home. If you are still working, you may be looking at only 2–4 weeks of annual vacation and weekends to escape to your desti­nation. Keep in mind working remotely via technology could increase your potential time away. If retired, you could be looking at a more extended use time. Renting your property at peak seasons may also conflict with your enjoyment of the property during these desirable periods. Perhaps you could consider purchasing a desti­nation that has appeal all year long, for instance Orlando serves snowbirds during the winter and Walt Disney vacationers during the summer.

Not only use time but travel time should also be evaluated before making a purchase. According to the 2014 NAR (National Associ­ation of Realtors) Investment and Vacation Home Buyers Survey, the median distance of a vacation home is 180 miles or roughly 3–4 hours away. For long distance homes, flight cancel­la­tions, delays and car rental access could lengthen travel time.

The financial aspects of owning a vacation home is a much more difficult hurdle to overcome. To mitigate the expenses and taxes, you could consider renting out your vacation home. Don’t be fooled. This is not as easy as you might think. For many high net worth house­holds, any losses from the rental property will most likely be suspended; i.e. not available to reduce current taxable income with AGI levels over $150,000 for married filing joint couples. The silver lining here is that when you sell the property, these losses will serve to offset capital gains. To further offset gains, owners should track and deduct all travel expenses incurred to check on your rental property. If you do not rent your home, mortgage interest for a first and second home up to $1 million, home equity debt up to $100,000 and real estate taxes can be deducted if you itemize on Schedule A. The 2017 Tax Cuts and Jobs Act (TCJA) limits the deduction to interest on the first $750,000 of a mortgage for homes bought after December 15, 2017.

According to the above survey, 31% plan to convert their vacation home to their primary residence so you might be thinking, “Can I reduce the taxes associated with the rental property if I sell the home as my personal residence?” According to IRC Section 121 capital gains taxes on up to 250,000 of gain for single filers ($500,000 if married filing jointly) will be excluded when you sell a home that you used as your primary residence for at least two of the previous five years. Taxpayers can take advantage of this exclusion once every two years. In recent years, Congress has amended Section 121 in order to limit the benefits when the property has been used as a rental.

  1. If you acquired the property in a 1031 exchange and then convert it to your primary residence, you must own it for at least five years before being eligible for the Section 121 exclusion
  2. The amount of gain that is excludable will be reduced to the extent the house was used for something other than a primary residence during the period of ownership. The exclusion is reduced pro rate by comparing the number of years the property is used from non-primary residence purposes to the total number of years the property is owned by the tax payer.

There is no doubt that reporting rental income on Schedule E adds to the complexity of your tax return. You may want to consider hiring a profes­sional tax preparer that has more expertise in this area especially if the rental property requires you to file a different state income tax return.

The elephant in the room is the added expense to run a second household that may be miles away. At the very least, you’ll need someone to regularly check the property for leaky pipes and damage caused by weather or vandals.

Owning a vacation home is indeed a luxury that will more times than not signif­i­cantly increase expenses. By carefully weighing the pros and cons of turning this dream into a reality, you can better achieve your goals and desires.

Origi­nally published August 2015