Now that the real estate markets may be stabilizing, perhaps you are considering joining the millions of Americans who own second (or more) homes. There are several different possible tax considerations that you should understand before you jump into the market.
You Are Entitled to a Tax Reduction if Your Second House is Not Being Used
If you have purchased a second home and do not intend to rent it out, you are entitled to deduct the real estate taxes and mortgage interest you paid on this residence. These deductions are claimed on Schedule A in the same manner that the deductions for your personal residence are claimed.
You are not entitled to claim deductions for any repairs, maintenance, or depreciation, although any capital expenditures (such as for repairs or maintenance) can be added to your cost basis and used to reduce the overall gain if and when you sell the property.
Property Used As A Rental
In this large category, you will obtain the most favorable tax breaks available to holders of real property. There are a few possibilities and these depend upon the amount of time that you personally use the property for non-rental uses.
You Didn’t Use the House for Personal Use
If you did not use the property for your own personal use (other than making repairs, painting, etc.), you will find yourself in the most favorable tax situation. All rental income and expenses, including advertising, repairs, interest, taxes, utilities, dues, etc. are deductible.
However, the most favorable deduction is depreciation. This will, in many cases cause the rental property to show a tax loss for the year, as this is not an out-of-pocket expense but rather a paper tax deduction. There are special rules for rental property losses, as this is considered to be a “passive activity” in most cases and, as such, there are limitations on the amount of the loss that you are entitled to deduct.
The Maximum Loss Permitted is $25,000 a Year
In general, the maximum loss permitted in any given year is $25,000, and this loss is permitted only if your total income for 2011 is less than $100,000. If your income is between $100,000 and $150,000, the loss is reduced and for any income above $150,000, there is no loss permitted. However, if you are unable to use a loss due to your income, this loss can be carried forward until your income does permit you to use it. Thus, you do not lose this valuable tax loss but instead must wait for the right time to be able to claim it.
Real Estate Agents Can Utilize All Losses Without Income Limitations
Real estate professionals (those spending more than half their time and 750 hours or more on their real estate activities) can utilize all losses fully without any phase-out or income limitations. If your property is treated as a rental property for tax purposes, all income and expenses are reported on Schedule E of your tax return or Form 8825 if the rental is held in an entity.
Some Personal Use of the Rental Property
If you used the rental property for your own personal use, the tax treatment will depend upon how many days it was used for personal reasons. If you used it for less than 15 days or 10% of the days it was available as a rental property, there are no limitations to the deductions other than the $25,000 rule as stated above. All expenses, including depreciation, are deductible and a loss can be recognized if you meet the income tests.
Tax Deductions for Your Property Rentals
However, the situation changes drastically if your personal use exceeds 14 days or 10% of the rental days. In this situation, you still are permitted to claim tax deductions for your expenses, but the expenses cannot exceed the rental income reported on the tax return. If your expenses for mortgage interest and taxes exceed your rental income, you are permitted to deduct any of the excess interest and/or tax expenses on Schedule A (this tax deduction is often missed).
For example, if you rent your real estate out for 300 days in 2011 and you used it for 12 days, you would be fine as your personal use was less than 10% of the days it was available for rent (30 days in this case) or 15 days. All of the expenses would be deductible and a loss would be permitted, assuming you meet the income requirements. If you used it for 25 personal days, no loss would be permitted.
Rental Property Rented Less Than 14 Days Per Year
In this category, you are not permitted to deduct any expenses except for mortgage interest, taxes, and possibly an uninsured casualty loss for the property. While this may sound like a bad deal, it is actually very good, as the flip side of this is that you are not required to report any of the rental income for this property. It does not matter how much money you received for the rental income– it is not considered to be taxable income.
This very favorable tax provision works well for many different locations in the United States. For instance, if you own a ski condominium in Colorado and rent it out over Christmas or Spring Breaks, you can charge a premium rental amount and have no income to report on your tax return. The same can be said for special events (such as renting your home to spectators at sporting events, such as the World Series, golf tournaments, Olympics, etc.).
Conversion to Personal Residence
If you sell your rental property, you will almost certainly be subject to capital gains taxes and possibly the need to recapture any depreciation claimed on the property. One possible way to save some dollars on taxes (although the depreciation recapture rules may still apply) is to convert your rental property into your personal residence before you make the sale.
In order to do this, you will need to satisfy the “two years out of five years” rules for ownership and occupancy. If you can do this, you will avoid the capital gains taxes and be able to qualify for up to $500,000 of tax-free gains (if you are married and filing jointly, otherwise it is $250,000). This tax treatment remains one of the best tax strategies for all Americans, as there are no income phase-out rules associated with this tax exemption.