A vacation home can be a great investment from both a financial and recreational standpoint. And with tax day at hand, it's a good time to consider some of the tax implications and benefits of owning a second home, if you're thinking of taking the plunge in the next year or so.

Many people don't realize that a second residence can qualify for the mortgage interest deduction, same as your primary home. You can write off all the mortgage interest on up to $1.1 million in loans used to purchase and improve the two homes.

This includes first and second mortgages, refinancing, home equity lines of credit, etc. - as long as they're secured by one of the two properties and you used the money to buy, repair, add on to or renovate the properties, you can deduct it, provided you stay below the total of $1.1 million for the two homes combined. To qualify for the full amount, at least $100,000 needs to be in loans for property improvements - a maximum of $1 million may be used for acquisition.

You can also deduct your property taxes on a vacation home as well. In fact, if you're fortunate enough to own more than two homes, you can deduct property taxes on all of them. But the mortgage interest exemption is limited to two properties.

Rental income - taxable or no?

Many owners of vacation homes like to rent the property out for at least part of the year to help defray the costs. In fact, you can rent it out for up to 14 days a year and not pay taxes on the income. In fact, you don't even have to list it on your tax return.

Rent it out for 15 days or more and you have to declare the revenue on your taxes. However, that also allows you to deduct part of your expenses for things like repairs, insurance and utilities. You need to pro-rate the share of expenses based on the ratio of time you used the property versus how long it was rented. Don't include any time the property stands vacant during the year.

Let's say you own a cottage on Lake Michigan that you close down for the winter. During the warm months, you use it for a total of eight weeks, including occasional use in the spring and fall, and rent it out for eight weeks during the summer. You can deduct half of your expenses, since the time the property is actually used is equally divided between personal use and rentals.

Residence or investment property?

Your deductions for expenses, though, are limited to the amount of rental income you actually take in. However, if you use your vacation home less than 14 days a year (or one-tenth the number of days you rent it out, whichever is greater), its considered an investment property and you can deduct the full prorated amount.

The downside, however, is that if your vacation home is considered an investment property, you can't take the mortgage interest deduction on it. So you need to figure out which is more important to you.

Although you can deduct the mortgage interest paid on a vacation home, you don't get the capital gains exclusion when you sell, unlike your primary residence, on which you're allowed to keep up to $500,000 in gains tax-free.

Retiring to your second home?

It used to be that you could get around this by selling your primary home and moving into the vacation home, then selling the vacation property two years later, the minimum required to establish residence. Many retirees found this an attractive option.

However, the law was changed in 2008 so that you can only exempt the gains on a pro-rated portion corresponding to how long you used the home as a primary residence. So if you owned it as a vacation home for eight years, moved in full-time for two and sold it at a gain of $100,000 over what you paid, you could exclude $20,000 in capital gains (one-fifth) from the sale.

Tax laws can have certain wrinkles that pop up for homeowners in specific situations, so, as always, consult with a tax professional before making any investment decisions regarding a second home.

Published on April 15, 2010