Your property usage and classification determine the tax treatment of your home purchase or investment. Unfortunately, property owners often confuse or conflate second homes and investment properties. Read on for a breakdown of the tax breaks and deduction considerations for each property option.
Before we dive into the tax implications for different types of properties, it’s important to understand the key differences between a second home and investment property.
A property is classified as a second home if the owner intends to occupy it on a regular basis. Second homes are particularly popular amongst older property buyers and often function as a vacation home when their primary residence is paid off. While requirements between lenders vary, most second home purchases must be located more than 50 miles away from your primary residence.
An investment property is a general classification for properties that have been purchased for income-generating purposes. To generate cash flow, investment properties are rented out to long-term tenants and tourists. If the homeowner decides to reside in their investment property, a portion of the building must be rented out for more than 180 days per year in order for the home to still be considered an investment property.
Tax Benefits of a Second Home
To categorize a property as a second home on your tax return, you must live in the house for a recorded portion of the year and it cannot be rented out for more than 180 days of the year. We’ve provided a quick rundown of the tax breaks you can take advantage of by owning a second home:
Personal and Rental Use Mortgage Interest Deduction
If your second home is strictly reserved for personal use, you will be eligible for personal mortgage interest deductions. In order to qualify for mortgage interest deductions on a second home, you will need a secured mortgage on a home in your name. Before you can deduct mortgage interest on your tax return, remember to file a Section 1040 IRS form with an itemized record of deductions.
If your second home is intermittently rented out during the year, a number of different tax conditions can apply. We’ve listed the three most common categories for rental use mortgage interest deductions:
- Income from renting the property for 14 days or less (per year) does not have to be reported to the IRS. Your second home will still be considered a personal use residence.
- If you stay at your second home infrequently and it is rented out for more than 14 days per year, the IRS will regard the property as a rental home. This means you can deduct mortgage interest payments, homeowners insurance premiums, property taxes, a percentage of depreciation, and property management fees on your tax return.
- If you reside in your second home for more than two weeks per year, the IRS considers the property a personal residence with rental provisions. This means the homeowner can only itemize mortgage interest and property taxes as deductibles on their tax return.
Selling Your Second Home
Unfortunately, second homes do not benefit from the $500,000 tax-free sale profit provision for primary residences. However, homeowners can reduce their capital gains tax obligations by employing the following tax structures:
- Make your second home the primary residence for two years — this will ensure that homeowners access a full or partial primary residence tax break.
- If you have been using your second home as a rental property, take advantage of a Section 1031 exchange to swap your property for a rental home of comparable or greater value. In most cases, you will not have to pay capital gains tax on a like-kind property exchange.
Tax Benefits of an Investment Property
The tax breaks afforded to investment properties are significantly more straightforward when compared with the tax treatment of second homes. While rental income must be itemized as a subset of your taxable income, investment property owners can benefit from the following tax benefits:
Rental Expense Deduction
The repair and management expenses for renting and maintaining an investment property can be deducted as an offset of annual rental income. Investment property expense deductions include insurance premiums, mortgage interest payments, property taxes, and property management fees.
Selling an Investment Home
To avoid paying capital gains tax on the profit of selling an investment property, homeowners can declare that the funds from the sale will be redirected into another investment property purchase. As long as you file an itemized Section 1031 tax-deferred exchange, the IRS will allow you to defer the payment of your capital gains taxes.
Still Confused? Connect with a Local Real Estate Agent!
If you’re still struggling to decide between purchasing a second home or investment property, consider reaching out to an experienced real estate agent. A good agent will guide buyers through the advantages and disadvantages of each option, breaking down the tax treatment, cash flow implications, and potential for capital growth. By partnering with an agent in the Clever Partner Network, prospective homeowners can benefit from a potential Clever Cash Back and on-demand showings for properties in competitive markets.