A Guide to Tax Deductions for Vacation and Investment Properties

Owning a second home has its perks, whether it’s a vacation home by the coast or an investment property in a hot market. But if you’ve recently taken the plunge (or are thinking about it), you’re likely wondering about the tax picture. Depending on how you use your second home, you may be eligible for some appealing tax perks. 

Review the potential tax deductions for second home ownership, like mortgage interest deduction, and some downsides, like capital gains taxes. From what qualifies as a second home to filing the right forms, we’ve got you covered.

What Qualifies as a Second Home?

Before shopping for tax savings, learn what qualifies as a second home. According to the Internal Revenue Service (IRS), not every property fits the bill. Their view separates a second home from a personal residence, which is typically your primary home.

The IRS Definition

For tax purposes, a second home is any additional residence you owned during the year outside of your primary home. It doesn’t need to be luxurious or large, but it needs to provide the basics for day-to-day living, like sleeping, cooking, and bathroom facilities. 

The IRS defines a dwelling used for personal purposes as one where the homeowner uses it for personal reasons. That definition affects the ability to claim deductions based on the proportion of time the property is rented versus used personally.

Second Home vs. Investment Property

Here’s the kicker: a second home isn’t the same as an investment property. A second home is purchased primarily for personal use, while an investment property is bought to rent it out or resell for profit. 

Usage Requirements

Classifying your property as a second home requires you to use it personally during the year. The lines get blurry when you use that second home part of the time and rent when you are not in residence.

The IRS has no problem with occasional rentals (more on “mixed-use” later). Still, if tenants occupy your rental property too often, the IRS might classify it as an investment property, making any tax deduction murky. IRS guidelines dictate the frequency of personal use based on the number of days. Meeting these limits is how to qualify for certain tax benefits.

Introduction to Mortgage Interest Deductions

Mortgage interest deductions allow homeowners to reduce their taxable income by deducting the interest paid on their mortgage. This deduction applies to primary and second residences, including vacation homes or rental properties. 

Naturally, the IRS has specific rules and guidelines for deducting mortgage interest. Learn the rules and regulations surrounding mortgage interest deductions to maximize tax savings.

Is Mortgage Interest on a Second Home Tax Deductible?

The short answer is yes, but there are stipulations.

Under current tax law, mortgage interest on your second home is deductible if your overall mortgage debt (across all properties) doesn’t exceed $750,000. Are you lucky enough to have a mortgage before December 16, 2017? Then, the old $1 million limit applies. 

Mortgage interest refers to the interest paid on home loans secured by a primary or second home used for purchasing, building, or improving the property. It’s defined as home acquisition debt. Mortgage interest paid on home equity debt, or carrying a second mortgage, is also deductible as long as its funds improved the primary residence or second home.

Conditions for Deduction

For your second home interest deduction to apply, you must meet these basic conditions:

• The property must secure your loan.
• The home must qualify as a second home per IRS standards (see above).
• The mortgage must fall within the $750,000 debt limit (or $1 million for loans 2017 and older).
• Only interest on loans to buy, build, or substantially improve a primary or secondary home qualifies for tax deductions as acquisition indebtedness.

If you check all these boxes, you’re on your way to deducting that second home mortgage interest.

Rules for the Mortgage Interest Deduction on a Second Home

Here’s where things can get a little tricky and working with a tax advisor helps. You’ll need to stick to a few IRS rules along the way.

Itemize Your Deductions

First, you must itemize your deductions on Schedule A of your tax return. This means giving up the standard deduction. Deducting interest from multiple mortgages might make the extra step worthwhile.

Watch for Mixed Use

Planning to rent out your second home on Airbnb or Vrbo? If so, keep track of your “personal use days.” The IRS allows rentals without impacting your deduction as long as you use the home yourself for more than 14 days (or more than 10% of the days it’s rented out). This number of days is very important.

To deduct rental expenses, accurately track the number of rental days and costs incurred to comply with IRS guidelines and maximize potential deductions.

Usage Matters

If you exclusively rent the property year-round, it likely won’t qualify as a second home. Instead, the IRS will consider it an investment property. That makes it ineligible for a mortgage interest tax deduction. However, investment homeowners do have other ways to lower their tax bills. Deduct expenses related to rental activities, such as repairs and maintenance, if the property is rented for more than 15 days a year. A tax advisor can help you follow IRS guidelines.

Deduction Cap and Limits

The deductible mortgage interest limits depend on the tax year and the type of debt. For tax years prior to 2018, the deduction limit was $1 million for married couples filing jointly and $500,000 for married filing separately. Beginning in 2018, the limit was lowered to $750,000 for single or married couples filing jointly and $375,000 for married couples filing separately. 

Remember, the state and local taxes (SALT) deduction cap is $10,000. It includes real property taxes, state income taxes, and sales taxes. 

How to Claim the Deduction

Claiming the second home mortgage interest deduction does require some paperwork. 

Reporting the Deduction

• Form 1098: Your lender will send you a 1098 form each year. The mortgage interest statement summarizes the interest you paid.
• Schedule A: Use this form to itemize deductions and claim deductible interest.

Documentation Tips

Save all records related to your mortgage payments, property use, and rental income. The IRS will double-check if something doesn’t add up. Stay on top of your paperwork.

Limitations and Exceptions

While the mortgage interest deduction is a valuable tax break, it’s not unlimited. Keep in mind these limitations.

Refinancing a Loan

When refinancing, a new mortgage retains its classification as acquisition debt if it doesn’t exceed the balance of the original mortgage, as with a cash-out refinance. That impacts the deductibility of points paid and the limitations for combining grandfathered debt with a new mortgage.

Alternative Minimum Tax (AMT)

If you’re subject to AMT, your mortgage interest deduction might be limited. AMT is a separate tax system designed to ensure high-income taxpayers pay a minimum amount of tax.

Refinanced Loans and Home Equity Loans

Only interest on your original loan or a refinanced balance used to “buy, build, or improve” the home is deductible. Loans taken out to buy, build, or substantially improve a primary or second home qualify for interest deduction. Home equity debt used for other purposes won’t be eligible.

Changing the Property’s Use

Are you deciding to rent out your second home or sell it? These changes can affect your ability to claim second home deductions moving forward. Also, selling a second home can trigger capital gains tax because they don’t have the Section 121 primary residence tax exclusions. Strategies like the 1031 exchange or converting a second home into a primary residence can help mitigate capital gains tax liabilities.

Comparing Primary vs. Second Home Deductions

The deductions for primary and second homes have many similarities, but there are key differences worth noting.

• For primary homes, you can deduct interest on a home equity loan used for non-property-related purposes (up to the debt limit). This isn’t an option for a second home.
• Second homes may have additional rules regarding rental income and expense reporting.
• Primary residences qualify for tax exclusions on capital gains when sold, unlike second homes, which are fully taxable upon sale. 
• When you have a home for personal and rental use, you must consider how rental income and expenses impact your individual income tax filing.

Frequently Asked Questions

Can I Deduct Interest If I Rent Out My Second Home?

Yes, you can, as long as you use the property personally for at least 14 days (or more than 10% of the days it’s rented out). Otherwise, different rules apply. Additionally, renting out a property has potential tax implications on your ability to claim income tax deductions and writing off various expenses.

What If I Have More Than Two Homes?

The IRS only allows you to deduct interest on two homes at a time (your primary and one other). Chatting with a tax professional is worth it if you’re in this boat. Be strategic about which home you use to deduct mortgage interest.

Does a Boat or RV Count as a Second Home?

Yes, the IRS considers it a qualified home if the boat or RV has sleeping, cooking, and bathroom facilities.

Maximize Your Second Home Deductions

Itemizing your deductions and keeping track of your usage helps save money on owning a second house. Remember, depending on the rental duration and the limitations imposed by the TCJA, you can also deduct property taxes alongside other expenses.

Consulting with a tax professional is the best step to maximizing your second home mortgage interest deduction and all your eligible deductions. After all, thoughtful tax planning isn’t just a perk of homeownership; it’s part of the strategy for enjoying your properties to the fullest.

Consulting a Tax Professional

A tax advisor helps homeowners understand the tax implications of owning a second home, including capital gains taxes, rental income, and property taxes. Together, develop a strategy to minimize liabilities and maximize tax benefits.