Owning a second home or a rental property on the South Shore, South Coast, or the Cape is a great way to either protect wealth or generate a second source of income. However, it’s important to understand that rental properties are treated differently than second homes when it comes to taxes.
A second home is defined by the IRS as a property that the owner uses for personal purposes for at least 14 days a year or 10% of the time the property is rented out, whichever is greater. If you don’t meet these conditions, your property may be considered a rental, with different rules for deductions, rental income, and sales exclusions. Rental properties, on the other hand, offer more significant tax benefits if you know how to navigate the tax code. Here are 7 key tips to help you make the most of your rental property:
1. Understand the Mortgage Interest Deduction
If you use a mortgage to finance your rental property, you can deduct the interest on the loan as a rental expense. Unlike personal homes, the $750,000 cap for mortgage interest deductions on personal residences doesn’t apply to rental properties. Keep detailed records of your mortgage payments to ensure accurate reporting.
2. Know the Rules for Rental Income
Earning rental income? The tax treatment depends on how often you rent the property and your level of involvement.
- 14-Day Rule: If you rent out your property for 14 days or fewer during the year, the income is tax-free. However, this primarily applies to personal residences, not dedicated rental properties.
- Regular Rental: For properties rented out more than 14 days, all rental income must be reported, but you can deduct expenses like maintenance, utilities, and property management fees.
3. Be Aware of Property Taxes
You can deduct property taxes paid on a rental property as a business expense, separate from the $10,000 SALT deduction cap that applies to personal residences. This is an important distinction for rental property owners in high-tax states like Massachusetts.
4. Track Expenses for Maintenance and Improvements
Keep records of expenses like repairs, landscaping, and utility bills. Routine maintenance is deductible as a rental expense, while improvements that increase the property’s value must be capitalized and depreciated over time. Proper documentation is essential for accurate reporting and minimizing taxes.
5. Consider Capital Gains Exclusions
When selling a rental property, the $250,000/$500,000 exclusion for personal residences doesn’t apply unless the property was your primary residence for at least two of the last five years. However, you may qualify for other strategies to reduce taxable gains, such as depreciation recapture planning or a 1031 exchange.
6. Explore 1031 Exchanges
If you’re selling your rental property and purchasing another investment property, a 1031 exchange can defer capital gains taxes. The rules are complex, so consult a tax professional to ensure compliance. A 1031 exchange is a powerful tool for real estate investors looking to build wealth without triggering large tax bills.
7. Passive vs. Active Income: Know the Difference
Rental income is generally considered passive income, which means it is not subject to self-employment taxes. However, if you provide substantial services to tenants, such as daily cleaning or concierge services, your income may be considered active and subject to different tax rules. Additionally, the length of tenant stays can impact tax treatment: short-term rentals often require more active involvement and may lead to reclassification as a business rather than passive rental activity.
Note: Active losses can be used to offset other active income, such as wages or business earnings, potentially reducing your overall tax liability.
Want to Maximize Your Tax Savings?
Owning a rental property can be both rewarding and financially beneficial with the right planning. To ensure you’re taking full advantage of these tax-saving strategies, consult with a Rom Neidhardt, CPA. We offer personalized advice tailored to your specific needs and can help you minimize your tax liability while maximizing your investment’s growth potential.
Schedule your free consultation today and start saving on taxes!