Vacation homes are often investment properties, because the owner of a vacation home hopes the property proves to be a good long-term investment. When that home is a rental or income-producing property, however, "investment" means something different and has different tax consequences. Depending on how you use your second home, Internal Revenue Service regulations will define your home as a personal residence or rental property.
How You Use the Property
If you plan to occupy the home for more than 14 days per year or more than 10 percent of the time it's rented, the IRS deems it a vacation home, regardless of your definition. Should you occupy the property for less than IRS minimums or not at all, you own a rental or investment property. The ways you use or occupy the home usually defines the property's true category for tax purposes.
Adjusted Gross Income Considerations
If you rent the home and do not use it personally, and if your modified adjusted gross income is less than $100,000, you can deduct up to $25,000 in real estate losses each year if you "actively participate" in your rental property. Active participation includes making meaningful management decisions and having an ownership interest of more than 10 percent. Your deduction amount becomes phased out if your income is between $100,000 and $150,000.
If your adjusted gross income exceeds $150,000, you can't deduct overall losses on the home in the current tax year. You may, however, carry forward these losses to future years to offset gains on this or similar property or if your adjusted gross income falls below $150,000 in a tax year.
IRS Vacation Home Definitions
The IRS has other rather liberal definitions of a second or vacation home. Besides a traditional house, your vacation home could be a time share property, a boat or even a recreational vehicle. As long as these other "homes" include sleeping, toilet and cooking facilities, you can take personal tax deductions for the interest you pay to finance them. But if you live in a second home or vacation home for more than 14 days in a year (or 10 percent of the total days that you rent it to others at a fair rental price), the IRS considers the home your residence ... not a rental or vacation home.
IRS "Have Fun" Rule
To qualify for the personal interest deduction on Schedule A of your personal 1040 tax return, the IRS wants you to have fun with your second home. If you treat it as a business only, occupying it for less than 14 days or 10 percent of the time it's offered for rent, the IRS considers it a rental investment property. No fun, in other words, equals no personal tax deduction. The IRS considers the vacation home a rental property whether or not you generate rental income from it on a consistent basis.
Rental Income and Expenses
If you use your second home and rent it for fewer than 15 days in a year, you need not report any rental income you receive nor can you deduct rental expenses. To be considered rental property, the home must be rented for fair market value rather than a nominal fee you charge friends or relatives. The IRS considers it a vacation home if you rent your home to your family or anyone at less than "fair rental price."
If your second home is classified as investment property, you can exchange it for a similar rental home without paying taxes on the transaction. This Section 1031 exchange, named for the provision in the IRS code, allows certain types of similar property to be exchanged without taxable gains being applied. Because the property must be held for investment, income production or other purposes involved in the taxpayer's "trade or business," vacation homes, which are considered personal residences, do not qualify.