Buying a Second Home

Homes can also be difficult to sell in a down market, making liquidity a problem if the owner needs to cash out on the investment. It's possible to hedge against a down market by sticking to some of the same home buying principles followed when purchasing a primary home. For the most part, location remains the golden rule.

In the same way that school systems and access to transportation increases the value of a home, there are things to consider when investing in a second home or vacation home. No doubt it's important to take a look at how close the home is to beaches, golf courses, lakes, mountains, and other recreational areas.

But also keep in mind the factors that may not be so obvious when assessing a vacation community. Make sure there is adequate access to the area including highways and public transportation. Also be prepared for the unexpected, which means easy access to hospitals and other healthcare facilities.

If a taxpayer is able to itemize deductions on their tax return; the interest expense on a second mortgage is tax deductible. The exact deduction that can be taken on a tax return may be limited if the mortgage exceeds the fair market value of the home. In addition, if the total of all mortgages (second home and primary residence) is in excess of $1 million ($500,000 for married, filing separately); the taxpayer may not be able to deduct all of the interest expense.

Real estate or property taxes paid can be claimed on a second home when itemizing deductions. In addition, any mortgage points paid when buying a second home are deductible over the life of the loan.

The exact tax rules that apply to rental income really depend on whether or not the second home is used as a residence. A second home is considered a residence if the owner or a family member use the home for personal reasons for more than 14 days each year, or 10% of the number of days that the home is rented (at fair market value), whichever is longer.

If a home is rented for more than 14 days, the owner must report the rental income on their federal income tax return. They can also report and deduct their rental expenses up to the amount of the rental income they're claiming. If itemizing deductions, then interest expense and taxes that are in excess of the rental income can also be deducted on a return.

The above rules do not apply if a taxpayer does not meet the residence test mentioned above. In that situation, they would report the income and expenses in the same manner as they would with other rental properties owned. For example, the only expenses they can deduct include taxes, interest, and casualty losses that are attributed to the taxpayer's use of the second home.