Second Home Tax Rules That Are Misunderstood or Overlooked

Many people purchase second homes without fully understanding the tax consequences. Second home ownership has some tax benefits, but it also carries potential tax traps that can be very expensive.

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Many people take for granted that they’ll be able to deduct the real estate taxes on a second home, but that’s often not the case.

Deductions for state and local taxes paid are available only to those who itemize expenses on their income tax returns. Then, the deductions are capped at a maximum of $40,000 under the One Big Beautiful Bill Act, and that ceiling is reduced for higher income taxpayers.

Property taxes on the primary residence and other state and local taxes are likely to exhaust the deduction limit, making the taxes on second home nondeductible.

Other state and local tax issues might arise when the primary and secondary residences are in different states.

Many states tax some of the income of part-time residents. Before buying a second residence in another state that has an income tax, check how it taxes the incomes of part-time residents.

When both states have income taxes, each state might claim you are a full-time resident and impose taxes on all your income. On the other hand, with proper planning you might qualify the lower-tax state as your primary residence, even if the other state initially was your primary residence.

The most important factor in establishing your primary residence is the number of days spent in each state. Often, the state in which you resided more than half the year is your state of residence or domicile. In many states, tax authorities also will look at other factors, such as where you vote and hold driver’s licenses, where vehicles are registered, the type of homeowner’s insurance on each property, and more.

Be sure you know about each state’s estate and inheritance taxes and probate rules.

The state in which real estate is located is likely to require the property to go through its probate process and be subject to its estate or inheritance tax, if it has one.

Probate and the death taxes often can be avoided by owning the property through an entity, such as a trust, limited liability company, corporation, or partnership.

Property owned by a trust usually avoids probate.

When you own the property through another type of entity, you own the entity, not the real estate. Ownership of the entity is personal property and should be subject to probate and death taxes only in the state of your principal residence. You might be able to take further actions to avoid probate of the entity in that state, such as owning it through a trust.

As with the income tax, each state with an estate or inheritance tax might assert it was your state of residence so it can impose taxes on your estate. The same actions that protect you from owing double income taxes protect you in this situation.

Even when you don’t want to convert your second home into a rental property, you might want to consider the tax break available for short-term rentals.

When a property, whether a primary or secondary residence, is rented for no more than 14 days during the calendar year, the rent received is tax free.

The rent doesn’t have to be reported on the tax return, and there’s no dollar limit on the amount of tax-free rent. You can’t deduct any expenses related to renting the home.

This tax break can be very helpful when one of your residences is near a major sports or entertainment event. Rent it to people attending the event and pocket the proceeds. Check IRS Publication 527, available free on the IRS website, for details.

Most people know that capital gains from the sale of a home are tax free up to $500,000 for married couples filing jointly and $250,000 for unmarried taxpayers.

For married couples, up to $500,000 of gain is tax free even when only one spouse was the home’s owner, if both spouses lived in the home as a primary residence for at least two of the five years preceding the sale. Otherwise, only $250,000 of the gain is tax free.

There’s no requirement to roll over the gain into another home purchase. The exemption applies to home sellers of all ages.

The trap is that the exemption is only for gains from the sale of a principal residence. All the gain from the sale of a second home or vacation home is taxed. When you owned the second home for more than one year, the appreciation will be taxed as a long-term capital gain with a maximum tax rate of 20%.

To exclude gain from the sale of a home, you must have both owned and used the home as your primary residence for at least two of the five years immediately preceding the sale. The ownership and residence periods don’t have to be concurrent and don’t have to be the two years immediately preceding the sale. That gives some flexibility to people who move out of a home but don’t sell for a few years.

The full exclusion is available no more frequently than every two years. When a home is sold for a gain less than two years after another home was sold at a gain, the exclusion of the gain from the second sale is pro rated based on how much time has passed since the exclusion was last used.

There are no bright line rules for determining when a home is a principal residence. The IRS will look at a range of factors that are very similar to those the states examine when determining whether to tax a person as a resident.

As with state income and estate taxes, the most important factor is the amount of time spent at each house. Other important factors include where mail is received, the address on the driver’s license and vehicle registrations, and the type of homeowner’s insurance policy.

A strategy some people use is to move into the second home and establish it as the new principal residence for at least two years before putting it on the market. It’s easier to establish the second home as the principal residence if you sell the original primary residence first, but it isn’t essential. But you want to compile proof that the second home became your principal residence.

Losses on a residence aren’t deductible, whether it is a first or second home. To deduct a loss, the house must have been held as a business or investment property, such as a rental property.

When gain on the sale of a second home is taxable, owners who know all the tax rules often can reduce the amount of taxable gain.

When computing gain on the sale of a home, the tax basis of the house is subtracted from the amount realized from the sale

Too often people think the tax basis is the amount they paid for the home. That’s only the starting point. Capital improvements that increase the value of the home or extend its useful life are added to the tax basis and eventually reduce the taxable gain. Regular maintenance and repairs that keep the house or its components in good operating order aren’t capital improvements.

There’s a tax rule that can bite taxpayers whose second homes are rental properties, whether they are rented full-time or part-time.

When the home is a rental property, the owner takes deductions for the cost of owning and maintaining the house, including depreciation of the basis of the building (but not the land).

When the home is sold at a gain, the depreciation deductions allowed in previous years are taxed, and the tax rate on this depreciation recapture can be as high as 25%. That’s not a reason to avoid treating the property as a rental. But it’s important to know when planning the property’s sale.

By Bob Carlson, Senior Contributor