The labor and housing markets are continuing to improve, but the market's shaky start to 2016 has caused the Federal Reserve to slow the pace of its plan for a series of interest rate hikes this year. As a result, interest rates remain at historically low levels — for now. So, if you have always wanted to own a second home, now may be an opportune time to take advantage of relatively low financing options. Depending on what you want to accomplish with your second home, there are tax and planning strategies to consider.
To Everything There is a Season...
A second home can provide a place for an extended family gathering. It can be a future retirement home in a more favorable tax state. Or, it can serve as a recreational retreat for favorite family activities. Whether seeking sun in the sand, fishing and boating at the lake, or swooshing down the slopes in the winter, the decision to purchase a vacation property involves a number of considerations. In addition to understanding your family's motives for owning a second home — vacation property, retirement home, investment opportunity — you should also consider location, type of home and the impact on your financial situation when thinking about fulfilling this dream.
A Time to Buy...
If you have decided that owning a second home is one of your goals, and that you're ready to take the next step, now may be a particularly good time to do so. A number of factors make buying a second home now desirable.
Prices Are Down and Sales Are Up
According to a National Association of Realtors (NAR) 2015 Investment and Vacation Home Buyers Survey, the median sales price of the typical vacation home is down approximately 11.1% from the previous year.1 Conversely, the same NAR survey reported a 57.4% increase in vacation home sales during the same time period. Additionally, with a number of popular retirement areas of the United States still recovering from the overspeculation of the housing boom, there is an even better pricing opportunity for many properties.
Mortgage Rates Remain Attractive
While many people expected interest rates to move higher in early 2015, the Fed kept its zero interest rate policy unchanged for most of the year, with rates rising only 0.25% in mid-December. Although the Fed has indicated plans to gradually increase rates in 2016, the market's expectations are for a slower pace than projected. Therefore, even if you had the ability to make a cash purchase, a low-interest mortgage may be a better financial strategy, often resulting in income tax savings.
The Tax Code is Still Friendly
When thinking of acquiring a second home, understanding the tax code can help. A mortgage on a secondary residence is tax deductible, just as it is on a primary home. For your first and second homes combined, you can deduct all of the interest you pay, up to $1.1 million, for acquisition or improvement indebtedness. You can also deduct property taxes on your second home, but generally can't write off other expenses like utilities.
A Time to Rent...
For many, owning a vacation home can be a dream come true. If you decide to rent the cottage when unoccupied, it can also offer an additional stream of income. The extra money in your pocket however, may come at a price if you fail to consult with a trusted accountant.
In addition to property management considerations, there are tax implications to renting your vacation home. Different tax rules apply when you rent the vacation home, depending on the breakdown of personal and rental use. Simply put, if you rent your home for 14 or fewer days during the year, you don't have to pay tax on the income. Alternatively, if you rent your house for more than 14 days, you must report all of the rental income. You can deduct rental expenses, but you need to accurately allocate costs between the amount of personal and rental use.
A Time to Sell...
Once a second home is acquired, many investors consider it like a family heirloom — hoping it will stay in the family, grow in value and pass to future generations indefinitely. However, that may not always be the case and you may decide it's time to sell.
The tax code that allows you to take up to $500,000 profit ($250,000 for single taxpayers) tax free on the sale of a primary residence does not apply if you sell your second home. However, if you make your second home your primary residence for two or more years prior to selling it, you may garner some tax benefits. Following the Housing and Economic Recovery Act of 2008, the IRS uses a ratio of the years the home was occupied as a primary residence after Jan. 1, 2009, versus the years it was rented after this same time period, to calculate the amount of capital gains that would be excluded from the sale.
Also known as a like-kind exchange or tax-deferred exchange, 1031 exchanges involve a seller swapping a rental or investment property for another rental or investment property of equal or greater value, on a tax-deferred basis. You may be able to avoid or defer paying capital gains tax on the exchange, provided the property is considered a rental property and not a personal-use residence.
A Time to Transfer...
Your family cottage is one of your most cherished assets and not only has it grown in economic value, it continues to grow in sentimental value. Therefore, proper and early planning is essential to keeping the cottage in the family and ensuring a smooth and tax-efficient transition to the kids and grandkids. It is also important to acknowledge that your wishes and desires may not be shared by the children. As a result, frequent dialogue with family members is the first step to understanding each person's long-term goals and views on the second home.
Once you have established a basic plan for your overall estate, including your primary residence, you should work with your accountant or attorney to review options for dealing with your second home. There are many choices for passing the property on to future generations. However, some are more complex than others and depend on variable factors such as the number of individuals in the next generation and their interest in the property, your charitable intentions and your time horizon.
Gifts—Outright or to Irrevocable Trusts
Gifting the property to the next generation is fairly simple, especially if taxes are not a concern. However, if your second home represents a significant percentage of your assets, gift and estate taxes may be incurred upon the transfer. A transfer at death gets a “stepped-up basis," which means that when the heirs sell the home, only the appreciation, if any, from the date of inheritance is subject to capital gains tax. There is however, a $5.34 million federal gift exemption. Amounts above that are subject to gift and estate taxes.
Qualified Personal Residence Trust (QPRT)
Another option is to transfer your property into an irrevocable qualified personal residence trust (QPRT). Sanctioned by the Internal Revenue Code, QPRTs offer several tax advantages, especially if you expect a federal estate tax obligation upon death. Using a QPRT, you make a taxable gift of your vacation home to your children or other beneficiaries but retain the right to live in the home for a set number of years. If you survive the trust term, the trust terminates and the cottage passes to the beneficiaries, free of any additional federal or state estate or gift taxes. One possible concern with this option is the possibility that if you fail to survive the term of the trust, the property will revert to your estate at its then fair-market value. In this scenario, you would lose the estate-reducing benefit of the QPRT, essentially voiding the entire transaction.
The benefits of a QPRT are only realized if the donor survives the term of the trust; therefore, it is critical to carefully structure the trust around life expectancy. Like many estate planning tools, a qualified personal residence trust may provide significant tax savings but can be complicated to execute. Individuals should consult with their attorney and other advisors to determine whether a QPRT is an effective strategy for their particular situation.
Limited Liability Company (LLC) or Family Limited Partnership (FLP)
Through the creation of a limited liability company (LLC) or family limited partnership (FLP), you contribute your property and assign a manager or general partner to handle maintenance and property management activities. Acting as general partner of the LLC or FLP, you can retain some control over the property. Use of this strategy also allows gifting of fractional interests in the home to the next generation, which may even qualify for the annual gift tax exclusion.
A Time to Act...
While a number of estate planning strategies exist for handling the transfer of a second home, none can be implemented without first deciding to take action. Interest rates are still near historic lows; though the Fed has clearly indicated its plan to begin to normalize interest rates later this year. With mortgage rates expected to remain relatively low near term, it is an opportune time to borrow relatively inexpensively and at a potentially tax-advantaged interest rate. With home prices down and inventory still available, that cottage can be in your family in a matter of months.