A second home warrants a second look at tax time
Because homeownership often opens up additional tax benefits, it also increases the likelihood of missing those tax benefits and shortchanging a tax refund. If owning a home is a common complication for taxpayers, owning a second home can be even more complicated.
“Owning a home opens up a world of tax benefits. Owning a second home often means greater benefits – and more work,” said Nathan Rigney, senior tax research analyst at The Tax Institute at H&R Block. “Homeowners should know about the tax breaks they can take advantage of so they get the most out of their second home at tax time.”
Itemize all possible deductions
Only one in three taxpayers itemize but millions more should – especially homeowners.
“Taxpayers only benefit from itemizing if their itemized deductions are bigger than the standard deduction,” said Rigney. “For many taxpayers, owning a home is what unlocks itemization because the largest itemized deductions are typically mortgage interest and real estate taxes.”
Taxpayers can deduct mortgage interest on up to two homes: one primary and one second home. Homeowners can also deduct their real estate taxes. Points, or prepaid interest, may be deductible in the year paid or over the life of the loan, depending on whether the loan is secured by the main home and several other factors.
Once itemizing is worthwhile, taxpayers can also deduct other qualifying expenses, like charitable donations, personal property tax, state and local income taxes or sales taxes, limited medical expenses and limited employee business expenses and other miscellaneous expenses.
Even if the individual expenses are small, adding them all up can make a difference to the taxpayer’s bottom line and be well worth the extra recordkeeping. For example, a taxpayer with a marginal tax rate of 25 percent could save up to $25 for every extra $100 they can itemize over the standard deduction.
Keep records to minimize tax on sale of a second home
When the time comes to sell a second home, taxpayers could find their gain from a sale taxed. They usually won’t qualify for the home sale exclusion which can reduce or eliminate their capital gain, unless they used the home as their main home for at least two of the last five years. Even so, they will likely not qualify for the maximum exclusion because their home was not their main home from the outset.
Still, taxpayers can decrease their tax bill if they can decrease their gain. To do this, they need to consider the cost of home improvements and selling expenses when figuring how much gain they had.
“Most people will of course have their HUD or closing disclosure statement showing their original cost, but they also need to keep records of substantial improvements and their costs,” said Rigney.
To qualify as an improvement, the home must have been upgraded in quality or size, restored to a functional state, or adapted to a new use. Maintenance costs, such as painting the home, do not count as upgrades increasing a homeowner’s basis.
Renting out a second home
“Renting out a second home is an easy way for taxpayers to generate income – and find themselves in a more complex tax situation than they expected,” said Rigney.
While there is no tax impact for renting out their residence for 14 days or fewer, the rules are more complicated for longer rentals. In this case, homeowners could be taxed on their rental income either as a landlord (Schedule E) or self-employed (Schedule C).
Long-term rental income and deductions
If they provide “substantial services” to their guests, they would be self-employed, meaning they may have to pay self-employment tax of 15.3 percent in addition to income tax. Substantial services include things like cleaning the rental while it is occupied, concierge services, tours, meals, entertainment or transportation.
Whether they are taxed on the rental as landlords or self-employed taxpayers, homeowners can generally deduct their expenses. If they did not use the property personally during the year, their expenses are generally deductible but subject to certain limitations.
In addition to deducting the costs of mortgage interest, they may also deduct costs for advertising, cleaning, depreciation, insurance, maintenance, repairs, real estate taxes, utilities and fees charged or withheld by a sharing platform.
If they did use the property personally, they can deduct only the expenses related by time and space to the rental.
Short-term rental income
If they reside or stay at the property during the year and rent it out for 14 days or fewer, taxpayers do not have to report any rental income.
“There is no dollar limit on this 14-day exception, making this a significant exception for hosts who can capitalize on short-term events in their area like a World Series, solar eclipse or presidential inauguration,” said Rigney.
Getting professional tax help can save money
Rigney says that the right tax professional will help make sense of the tax requirements and help the taxpayer get the most out of their new place.
“Not only can a qualified tax professional who specializes in rental income help taxpayers identify ways to lower their taxable income and claim all the tax benefits they’re eligible for, but the cost of tax preparation may even be a deductible expense,” said Rigney.
Rigney says a qualified tax professional should have up-to-date and ongoing training, have expertise in small business and self-employed tax requirements and benefits, guarantee their work and be available year-round.