The impact of the Covid-19 pandemic on the residential housing market has been dramatic—from the sales slump in March 2020 to the robust market and double-digit price appreciation beginning in mid-2020 and continuing through 2021. In April, the Commerce Department reported that the median sales price of a new home was $372,400—up 20.1% from the prior year.¹ Sales of high-value homes over $1 million tripled since April 2020 and, despite reports that city dwelling values are down, the Case Shiller 20-city index rose 13.3% in March 2021.²

The current frenzy in the real estate market is caused in part by lack of inventory, the slowdown in building over the 18 months, the high cost of building materials and the “work from home”—“learn from home” dynamic creating a demand for larger homes further from central cities.  In fact, a recent Redfin study states the demand for second residences and vacation homes has more than doubled from pre-pandemic levels.³

Yet even in such a strong sellers’ market, the rest of 2021 may be an opportune time to take advantage of relatively low financing options and buy a second home. With 30-year fixed mortgage rates hovering around 3%, these low rates continue to fuel a strong market, as more inventory becomes available and home building ramps back up. If you do decide to make the move on that second home, here are some tax and planning strategies to consider.

There's a season for everything...

A second home can provide a place for extended family gatherings. It can be a future retirement home in a more favorable tax state. 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 several 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.

A time to buy...

If you have decided that owning a second home is one of your goals, your next decision will be to consider the timing of when to make a purchase. Is it now? Several factors may make buying a second home desirable now. While housing prices are currently rising, so have investment portfolios. On the flip side, interest and mortgage rates remain historically low. Partially liquidating an investment portfolio to fund a second home purchase may be an appropriate asset allocation decision but will likely result in a capital gains tax. An alternative to portfolio liquidation could be to use a secured line of credit, mortgage, or a combination of both. This combination approach could give you the ability to win the bid with an all-cash offer and then secure mortgage financing within 90 days to qualify for a tax deduction.

Mortgage rates remain attractive

While investors have enjoyed historically low interest rates for several years, many expect a gradual increase by the end of 2021. The Mortgage Bankers Association, for example, forecasts the 30-year fixed rate to reach 3.5% by the end of 2021.⁴ Still, rates are very attractive for those who are ready to buy. Even amid a sellers' market, it makes more sense to buy now and lock in such a low cost of financing than to wait a year or more. 

Tax code is still friendly

Understanding the tax code also helps when you’re thinking of acquiring a second home. A mortgage on a secondary residence is tax deductible just as it is on a primary home. Generally, mortgage interest on first and second homes acquired before December 16, 2017 are deductible up to $1 million in outstanding debt. After December 15, 2017, the limit of deductibility was reduced to $750,000. Real estate taxes are deductible, but under the state and local tax (SALT) provisions of the Tax Cuts and Jobs Act, they are limited to $10,000 until 2026.

A time to rent...

For many, owning a vacation home can be a dream come true, and can also offer an additional stream of income if you decide to rent it when unoccupied. 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 a 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 can retain the income tax-free.

Alternatively, if you rent your house for more than 14 days, you must report all of the  rental income. You can, however, deduct rental expenses, but you need to accurately allocate costs between the amount of personal and rental use.

A time to sell...

While many investors initially considered their second home to be a family heirloom— hoping it will stay in the family, grow in value and pass to future generations indefinitely —they may find the property isn’t used that much and the cost of maintenance outweighing the benefits. Given the recent surge in price appreciation, it may be the right time to sell. If so, there are some tax considerations to keep in mind.

The tax code allows you to take up to $500,000 profit ($250,000 for single taxpayers) tax free on the sale of a primary residence, but this doesn’t 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 calculates the amount of capital gains that would be excluded from the sale by using 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.

1031 Exchanges

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. Note that the White House recently proposed increasing the capital gains tax for high income taxpayers from 20% to 39.6% and reducing or eliminating 1031.

A time to transfer...

Your family cottage is one of your most cherished assets that’s grown in economic value and sentimental value. As a result, proper and early planning is essential to keeping it 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. 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. Some, however, are more complex than others and depend on factors such as the number of individuals in the next generation and their interest in the property, as well as your charitable intentions and time horizon.

Gifts—Outright or to Irrevocable Trusts

Gifting the property to the next generation is straightforward, 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 $11.7 million federal gift exemption per donor; amounts above that are subject to gift and estate taxes. Note that a recent White House proposal may reduce or eliminate the stepped-up basis.

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(s) survive the term of the trust; therefore, it’s 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 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.

Proposed legislation

The purchase—or sale—of a property should be considered in the context of proposed legislation. The current administration has proposed tax changes that would impact home ownership including increasing the capital gains rate on the sale of property, eliminating in part the step-up in basis at death, and curbing the 1031 rules. It is only a guess as to which, and when, any of the proposals become effective. And while there’s a chance they could be retroactive to the beginning of 2021, the considered opinion is that changes will be enacted in 2022.

A time to act...

While several estate planning strategies exist for handling the transfer of a second home, none can be implemented without first deciding to own one. Interest rates are still near historic lows; though the Fed has clearly indicated its plan to begin normalizing rates later this year. Therefore, the benefits resulting from cost-effective financing at a potentially tax-advantaged interest rate are at their peak. The time to act is now.