If you own a second home or a vacation home, you might have asked yourself, Can I rent my property for profit? There are benefits to doing so, but you’ll need to weigh them against personal needs and conveniences. For example, would the financial benefits of renting your property outweigh the benefit of using it any time you want? You’ll also need to weigh the benefits against guidelines set forth by the IRS.
Changes to tax laws due to the Tax Cuts and Jobs Act of 2017 make owning a vacation home more expensive for certain investors. Combined mortgage interest on a first and second is now deductible up to $750,000. For example, if your main residence mortgage is $600,000, you would only be able to deduct interest on $150,000 of your secondary home mortgage. If you convert your second home into a rental property, it would no longer fall under the combined deduction restraint.
Understanding the rules associated with converting a second home to a rental property can help you determine if doing so is a smart move based on your unique situation and financial strategy. Let’s first look at the IRS guidelines surrounding the use of a second home as rental property.
Can I Rent My Property? Rules on Converting a Second Home to a Rental Property
The IRS stipulates what deductions you can take based on the type of property you own, and it all comes down to the number of days you use your property for personal purposes.
If you use a home for both rental and personal purposes, the tax treatment of the rental expenses and income depends on whether, in the eyes of the IRS, you are using the dwelling unit as a home:
You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:
- 14 days, or
- 10% of the total days it is rented to others at a fair rental price.
If a dwelling unit is used for personal purposes on a day it is rented at a fair rental price... don’t count that day as a day of rental use in applying (2) above. Instead, count it as a day of personal use in applying both (1) and (2) above.
Day of use for “personal purposes” and “fair rental price” are strictly characterized by the IRS and used to determine if your dwelling is defined as a home. If it is, you would not be able to enjoy the tax benefits of a rental property.
Top Seven Benefits of Converting a Second Home to a Rental Property
Now that you know the stipulations associated with turning your second home into a rental property, you need to determine whether or not conversion is wise. As noted earlier, there are benefits to doing so:
- Income: For some investors, vacation homes are sanctuaries that are used quite often. Other investors own homes that sit empty most of the year. If you fall into the latter category and meet the IRS guidelines above, converting a second home to a rental property will generate income that can be saved for retirement, used to fund a child’s college education, or used to build a portfolio of multifamily investments.
- Tax Deductions: Rental property mortgage interest, property taxes, and expenses, such as cleaning, repairs, and utilities, are tax deductible if you meet IRS guidelines. If you were to rent your vacation home but not meet those guidelines, you could only deduct a certain percentage of the expenses on your taxes, commensurate with the personal time spent in the home vs. the rental time.
- Depreciation: Not only can you deduct expenses when you convert your second home into a rental property, but you can also depreciate your second home like you would any business. This tax deduction can help you recover some of the cost of the property itself. The only thing to consider when depreciating is that you lower the cost basis of the property (its value for tax purposes). The cost basis is used to factor how much money you make if and when you sell the property. Reducing that amount could cause a large capital gain in the future.
- Wait out a struggling market. If you want to sell your property, but a market downturn tells you the timing isn’t right, consider renting it for a year or two before selling. This would generate income and help you avoid the possibility of taking a loss on the property during a difficult economy.
- Fewer Surprises. When you consider buying a rental property, one of the first things real estate investors will tell you is that you should expect some surprises as you do your due diligence. The foundation might need work, the plumbing may have been poorly maintained, and so on. But when you convert your second home or vacation home into a rental property, there are most likely far fewer surprises. You have maintained the property, made improvements, etc., and can therefore feel more secure in your decision.
- Build home equity. If your second home is located in an area in which property values are rising, you can expect your home equity to increase as you pay down your second mortgage. This is great news for you, because it gives you options to pull some of that equity out when you need to or eventually sell the property for a profit.
- 1031 Exchange: Because your vacation home is considered a rental property (if you follow the guidelines set before), it is eligible for a 1031 exchange, which allows you to defer taxes due on any gain from the sale of your property if you use the proceeds to buy a similar property. You will need to report this sale to the IRS on Form 8824 and file it the same year in which you exchanged the property.
You can certainly rent your investment property, but understanding IRS rules and the benefits of conversion will help you decide if doing so is a wise and profitable decision.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country, and employ a team of experts who can help you hone your investment strategy.
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