Thinking of a Second Home? Not So Fast.

Mar 16, 2021

Spending more time in your house than out of it over the last year may have your wheels spinning on buying a second home. Mortgage rates are low, and the real estate market is thriving. But don’t get caught up in the hype! The thought of having a place you can safely escape to is exciting, but make sure you are fully informed of the costs, tax impact, and estate planning considerations.

Total costs

Mortgages for non-primary residences can require a higher down payment and may carry higher interest rates. Don’t forget to include additional insurance premiums such as flood, earthquake, and hurricane insurance. Insuring a vacation home can cost up to 20 percent more than insuring your primary residence. Some states also impose higher property taxes on non-residents than on residents.

Renting the property can offset some of these expenses. You may even generate a positive cash flow. However, renting also means carrying additional medical and liability coverage. If you decide to use a property manager, this will also increase your costs.

Tax Consequences

The tax treatment of rental income is based on the number of days the property is rented and the number of personal use days. If the home is rented for less than 15 days in a calendar year, the rental income is tax-free, and both property taxes and mortgage interest are eligible to be deducted. In this scenario, rental expenses such as utilities, advertising, and maintenance are not deductible.

If the home is considered an investment property, certain expenses and depreciation are deductible. However, annual personal use is restricted to 14 days or 10 percent of the total days rented, whichever is greater. If you meet these criteria, income is reported as rental income, and items such as mortgage interest, property taxes, insurance costs, and other rental expenses are eligible to be deducted. However, you must pro-rate the deductions relative to personal use versus rental use.

If you rent the home for more than 15 days each year and your personal use is greater than 14 days or 10 percent of total days rented annually, your income tax benefits are limited. Rental income is taxable and rental expenses are only deductible up to the amount of rental income. Any excess expenses can be carried over to offset future rental income.

Selling the property will generate a capital gains tax on the amount of proceeds over your purchase price, plus the cost of any improvements.

Estate Issues

Review your situation with an estate attorney if your vacation home is in a different state than your primary residence. If the ownership is in your name only, the vacation home could be subject to probate in its respective state.

As you can see, purchasing a second home should not be an impulse decision. It requires diligent research and financial commitment. While it would be enjoyable to escape to your vacation home at a moment’s notice, it needs to fit into your overall financial plan.

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