Although the Tax Cuts and Jobs Act aimed to simplify the tax code, there were several changes that may make owning a vacation home more expensive. Also, some of the changes to the tax code change how you need to record personal use of vacation homes and how to record rental expenses from vacation homes. These changes apply to homes that are rented for more than 14 days a year and personally occupied for more than 14 days a year.
IRS vs Court Methods of Deducting Vacation Expenses
If you aren’t familiar with the debates and case laws around deducting vacation expenses, you may find the Journal of Accountancy’s overview of the differences between the IRS and the “court methods” to be helpful. One of the large differences between these two points of view is how the ratio of days occupied is calculated. The tax courts have sided with taxpayers who wanted to use a ratio of days occupied vs the days in the year. The IRS wanted them to track the ratio of days occupied by renters vs days used for any other purpose.
Tracking income and expenses for renting out vacation homes continues to be a complicated process and the IRS only publishes their method (ratio of days rented to days used for any purpose).
Lower Cap on Deductible Mortgage Interest
Mortgage interest deduction depends on the total amount of mortgages a taxpayer has. Before the Tax Cuts and Jobs Act was passed, married-filing-jointly homeowners could deduct interest on mortgages up to $1 million. After tax reform, this amount is reduced to $750,000. Since many vacation homes are in more expensive areas, the reduction of $250,000 in debt principal for mortgage interest deductions means that most vacation home owners will have to reduce their write-offs from mortgage interest.
This lower cap applies across all mortgages, not per property. So, if you have two residences with two mortgages, they will both be considered and the interest on any mortgage amount over $750,000 will not be considered as a deductible expense.
This means that many second homeowners are going to be paying more in taxes resulting from lost mortgage interest deduction.
Limit on State and Local Tax Deductions Impacts Vacation Home Costs
Another major impact for vacation homes and taxes is the reduction on SALT (State and Local Tax) deductions. Before, people with properties in high-tax areas could deduct all their tax expenses at the local level from their federal income tax. This deduction saved significant amounts of money but will be greatly reduced with the new $10,000 deduction cap.
The tax reform’s cap on SALT tax deductions means that many vacation homeowners will be paying federal taxes on the local taxes that they pay for their rental homes, resulting in a higher cost to maintain a vacation home.
Rental Deductions in Non-Residence vs Residence Real Estate
The IRS continues to change tax policies on rental vs non-rental second homes. A home is considered a residence if it is occupied by the owner for the greater of 14 days or for “10% of the total days you rent it to others.” If the homeowner dwells in a house for 30 days and rents it out for 320 days, then the home is not considered as a residence.
When a vacation or second home is used as a rental and a residence, you must track the expenses for both personal use and rental use. Expenses from a home that is only a rental, not a residence, may exceed the amount of income in a given tax year according to the IRS’s at-risk rules and passive activity loss rules.
For residences that are rentals, certain expenses may be carried forward to following tax years, depending on the gross rental limitations of the year.
Vacation Home: to Buy or Not?
While the tax costs of owning a vacation home have increased because of the SALT taxes and reduction in deductible mortgage amounts, owning a vacation home still makes sense if you consider these tax changes before choosing where you will buy and how you will monetize your new home when you are not using it.
With rental companies like Airbnb, you may be able to rent out a second home more than 90% of the time you are planning on using it. If you were to treat this as primarily a rental unit by the IRS’s definitions, then the tax costs would fall under a rental investment, not a home.
On the other hand, if you can find the right property in the right market, the increased tax costs will be more than offset by the capital gains from buying this property.
The Tax Cut and Jobs Act changed the way property owners will approach buying their second home, but with the right record-keeping and planning, a second home is still a profitable way to grow your equity.