FEDweek

Using a Second Home for Income

If you have a second home you might want to rent it out either periodically or on a long-term basis.

If you rent it out periodically, you should try to keep your personal use to less than 14 days per year or less than 10 percent of the days the home is used. Once you get over the 14-day or 10 percent thresholds, your vacation home is classified as a residence and deductions are limited.

If you stay under the 14-day or 10 percent limits on personal use, your second home will qualify as rental property. This may permit you to deduct repairs, maintenance, insurance, and depreciation costs. If your expenses exceed your income, you can deduct the loss, subject to the passive loss rules.

If you’re over the 10 percent limit and your second home is classed as a residence, you only can deduct expenses up to the amount of rental income. What’s more, before you can deduct any operating expenses or depreciation, you have to use your mortgage interest and property tax deductions first, in effect wasting deductions.

Renting it out to long-term tenants can be a hassle but the financial rewards may be worth the bother:

Current income. Landlords collect rent from tenants; over the years, increasing rental income can provide another source of cash flow.

Appreciation. Historically, real estate values generally have increased.

Leverage. Rental property can be bought largely with borrowed funds, increasing the effective return if the property gains value. Say you buy a house for $200,000, with a $40,000 down payment. If the property doubles in value over the years, to $400,000, you’ll have a $200,000 gain on a $40,000 outlay.

What’s more, when you borrow money to buy investment property, the property usually secures the debt so your other assets are not at stake. You have unlimited upside potential with limited losses.

Tax advantages. If you do receive net cash flow from the property, after expenses, some or all of that income may be tax-free.

Whether or not you have positive cash flow, you may wind up with a loss, for tax purposes, and such a loss might provide you with a tax deduction. In addition: you can pull out tax-free cash by refinancing your loan, if the property appreciates; you can enter into a tax-free exchange if you want to switch investment properties; you can eventually sell the property and pay tax at favorable long-term capital gains rates.