Tax considerations before renting out a second home

Renting out a second home or vacation home for part of the year can actually be an excellent way to earn additional income and get a nice tax break at the same time.

Of course, as always, there are rules you need to follow:

– If you rent your home or vacation home for 14 days or less, you don’t need to report your rental income on your tax return.

– You can deduct expenses for your rental home on your return even if you don’t have tenants, as long as you are actively seeking tenants. One way to document that you are actively seeking tenants is to clip out and save an ad in the newspaper showing that your rental home is available.

– You can deduct up to $25,000 of rental losses on your tax return if your adjusted gross income is less than $150,000. If you are renting to a family member, you can deduct your rental loss if the family member is paying a fair rental price and uses the home as a principal residence. This fair rental price can be as low as 80 percent of the amount of rent you would charge a non-family member, since the courts have ruled that there are fewer risks with renting to family members.

– You are not limited to $25,000 in rental losses on your tax return if you are a real estate professional. If you spend more than one half of any job or business-related time doing your real estate business and spend more than 750 hours on your real estate business, then you are a real estate professional.

– When evaluating whether to acquire or keep a rental property, you should look at the cash flow potential. Most rentals show a tax loss since depreciation of the rental is usually a significant deduction on the tax return. However, many rentals still have a positive cash flow. If the amount of rental income and the tax benefit of the rental loss aren’t going to be enough to cover operating expenses, such as the mortgage payment, property taxes and insurance, you may reconsider acquiring or keeping the rental.

– Besides cash flow, other factors in your decision would be what you expect the appreciation of the home will be and whether you could get a better return on investment if your cash was invested elsewhere.

– Always take depreciation on your rental home. Some people don’t want to bother taking depreciation on their home if they are planning to rent their home for a year or two before returning and making the home their principal residence again. However, the IRS considers depreciation to be taken on your rental home for the period it was rented whether or not you take the depreciation on your tax return. So when you eventually sell the home, gain needs to be recognized to the extent of any depreciation taken (or what should have been taken).

– If you sell your principal residence and qualify for the exclusion of gain, you do not have to recognize any depreciation that you took on the home prior to May 6, 1997. For example, you rented your home between 1992 and 1995 while working out of state. You moved back into the home in 1995 and eventually sold the home in 2003. The gain on the sale of the home is less than $250,000. You don’t have to report anything on your 2003 tax return, since all of the depreciation that you took on the home was taken prior to May 6, 1997.

– If your rental home is your principal residence for two out of the previous five years before the sale of the rental, you qualify for the $250,000 ($500,000 for married filing jointly) exclusion of gain on the sale of your residence. Better yet, any depreciation taken on the rental before May 6, 1997 does not have to be recaptured as income when the rental is sold.

For example, John Doe has owned a rental home for the past 30 years that he originally purchased for $20,000. The rental home has been fully depreciated so the home’s basis is zero. John moves into the rental home and uses it as his principal residence for two years before selling the home for $200,000. Since he qualifies for the exclusion, all $200,000 of gain he would have had to recognize as capital gain and ordinary income is excluded from income. He pays zero taxes on the sale instead of the $41,000 or more in taxes he would have paid if the rental home did not qualify as his principal residence.

– In order to qualify for the $250,000 exclusion, a home must be the taxpayer’s principal residence. If you own multiple residences, simply living in a home may not be enough to prove that the home is your principal residence. Physically occupying a home is just one factor to be looked at. Other facts and circumstances are the address shown on your tax return, your voting place, the address shown on bank statements and other documents, car registration, location of children’s school, location of your business, driver’s license and club and church membership.

Basically, the more facts and circumstances that you can show as proof that the home you sold was your principal residence, the stronger your case is for using the sale of principal residence exclusion. nhbr

Sean C. Sullivan is a certified public accountant with Nathan Wechsler & Company, which has offices in Concord and Laconia.

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