What is a Hawaii second home as defined by the IRS?
Buying an Oahu vacation home is a dream for many people, and with good reason, who wouldn’t like having their own piece of paradise! It’s as much a spiritual investment as it’s a financial one. There’s not much else that can beat living in Hawaii with your family amidst sublime natural beauty in a tranquil and serene environment.
Everybody deserves a break from the hustle and bustle of their routines. Life moves at a leisurely pace in the islands, allowing you to relax and create lasting memories with your loved ones by being in the present. What’s great is that you don’t need to sacrifice any modern conveniences to achieve this. Owning a second home in Hawaii only adds to your lifestyle, it doesn’t take anything away.
Buying a second home is also a significant investment and you should be aware of its financial and tax implications. The IRS treats second homes differently than they do investment properties. That’s why you should understand how the IRS treats second homes so you can figure how you can maximize the financial benefit from this investment.
This is a short guide on how the IRS defines what is a second home. We're also obligated to point out that the guide is for educational purposes only and you should consult your tax professional and accountant to ensure compliance with legal liabilities based on your needs.
The IRS definition of a second home
The IRS definition of a second home isn't very complicated. It can be any property such as a house, co-op, condo, apartment, etc. The IRS defines it as a residential property that's not used by the owner as their primary residence, but it must not have been bought for use as an investment property. You're only required to visit your second home for a set number of days per year in order for the property to retain its classification.
You could own one, two, four, or even more homes and it's possible that none of them are considered a second home by the IRS. Simply owning properties other than your primary residence doesn't fulfill the IRS qualification for a second home. On the flip side, it's also possible that more than one of your properties is considered a second home.
The IRS treats second homes differently from an investment property. The latter are purchased for the main purpose of generating income through rentals or other commercial activities. A second home is primarily a personal residence for the owner, even if for a few days each year, and you're free to keep it vacant or rent it for the remainder of the time. The personal residence requirement must be met for a property to be considered a second home by the IRS.
As the owner, you're required to live in the second home for at least 14 days out of the year. If the property is being rented out, then the owner must use the home for at least 10% of the days that it has been rented out. For example, if you rented the home for 40 weeks out of the year (280 days) then you would need to use the home for more than 28 days for the home to qualify as a second home. This is required to pass the IRS litmus test for mortgage interest deduction but it's still possible to face difficulties in arranging financing for the property. Some lenders may not offer second home financing if the owner plans on renting out the home part time.
It’s common for many who own a vacation home in Hawaii to meet that minimum residence requirement every year while also renting the place for additional income. If you rent out your second home for no more than two weeks in a year, you don't have to pay any taxes on the rental income. If the property is rented for more than two weeks a year, you must report the income from those transactions to the IRS and you're allowed to deduct some property ownership expenses.
Second homes that meet this criteria aren't considered investment properties so they can't be depreciated in the same way investment properties can. Do remember that personal and rental use of your second home creates different tax liabilities.
For most homeowners, it makes good financial sense to have a second home, as they can take advantage of many tax deductions to reduce the cost of owning a second home. Leveraging these tax benefits can make your dream of a Hawaii vacation home a reality.
Defining Basic Living Accommodation
Whether it's a house, a condo, an apartment, or even a mobile home, regardless of the type of property, it must meet some minimum living requirements in order to be considered a second home. The property must have basic cooking, sleeping, and toilet facilities. A property that has these facilities can thus qualify to be considered your second home.
There's a wide variety of eligible properties available for you to purchase in Hawaii and in particular on Oahu, where we are located. If you are looking for a property with little maintenance that you can lock up and leave, you may consider affordable and luxury condos in Waikiki, Ko’olina, and Turtle Bay on the North Shore. Only properties in these areas (resort zoned) can be rented out for 30 days or less. Kakaako is a hip, up and coming area in Honolulu with luxury towers and a walkable world at your fingertips that may be a great option as well.
Single family homes are also highly sought after by second home buyers in Honolulu with Diamond Head and Kahala being two of the most desirable close to Honolulu. Beachside and Lanikai in Kailua gives you a smaller boutique beach town vibe and the North Shore would give you that more quiet and removed setting in the heart of surf country.
Mortgage And Tax Differences
The IRS provides multiple tax benefits to second home owners but they're dependent upon several factors. The primary consideration is whether the property is being used as a personal residence or being rented out for the majority of the year.
Related: Get Pre-Approved for a Home Mortgage
Mortgage interest deduction
If you rent out your Hawaii vacation home for less than 15 days a year, it will be considered as a personal residence, and thus you'll be able to make itemized deductions. If you take out a mortgage to buy, construct or renovate a second home, the maximum mortgage principal eligible for the deductible interest is $750,000 for married couples filing jointly and $375,000 for single filers as well as married couples filing separately.
Also, if you and your spouse are in the 24% tax bracket and have paid $20,000 in mortgage interest on a $750,000 mortgage for your second home, your mortgage interest deduction would be calculated as follows:
Mortgage Interest Deduction = $20,000 x 24% = $4,800
This deduction would thus reduce your taxable income by $4,800. There's a common misconception that all of the interest paid on the mortgage is deductible. That's not true. As evident from the example above, the actual deduction is based on your tax bracket.
It's important to note that this deduction limit is shared between two personal residences so it includes your primary residence and your second home. You can’t deduct more than the limit for both properties.
If you take out a home equity loan or line of credit on the property, the interest on that is fully deductible as well. To avail this benefit, you must have a mortgage on your second home and utilize the home equity loan to make improvements to the property.
Remember, these mortgage interest deductions are only available to those who don’t rent out their second home for more than 14 days in a year. You don't get a mortgage interest deduction if you rent out your second home in Hawaii for more than 14 days a year.
Property tax deduction
A property tax deduction is allowed on all of the properties that you own, not just your second home, but there's a major caveat that will prevent you from extracting additional benefits from this deduction. There is now a limit on the total state and local tax deductions a person can take in a year.
The Tax Cuts and Jobs Act placed a limit on deductions for state, local, and property taxes in 2018. This limit applies to all property taxes in addition to any state or local taxes. Currently, the limit is $10,000 per tax return, or $5,000 if married and filing separately.
If you’ve already paid more than the limit with your first home, buying a second home won't make it possible to take additional property tax deductions, regardless of whether you live in it or rent it out.
Tax-free rental income
The IRS doesn't require you to report or pay taxes on any rental income, provided that you have only rented out your home for 14 or fewer days. So if you intend on renting out your Oahu vacation home for two weeks every year, you can effectively clear that as tax-free rental income, provided that you meet the minimum residency requirement.
You will be required to report the income if you rent your second home for 15 days or more. The IRS will allow you to deduct relevant rental expenses. Deductions are only allowed up to the amount of the income, excluding any deductions claimed for interest and taxes.
Benefits of owning a second home in Hawaii
If you’re thinking about buying a Hawaii vacation home as your secondary residence, you may want to think about the potential benefits. You may be wondering, we’re buying this property in Hawaii so how do we treat it and handle it, what are the different ways this property can serve us and how can we get the most out of it?
Perhaps you’re not approaching the idea with the objective of renting it out. In that case, you’re buying property in one of the most serene places on the planet. It’s an incredible investment to make for improving your quality of life. Your Oahu second home would be the place you go to so that you can get away from it all, enjoy some much-needed downtime, and experience nature in all its glory. It’s hard to put a price on that.
Related: Buying Your First Home in Hawaii
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