Buying a Second Home? 4 Tax Considerations
Buying a vacation property is a great investment goal if you know how to maximize the income and tax deductions.
Remember to think through how your usage options may impact the bottom line.
When you sell the property you will be subject to capital gains, just like any other asset.
Buying a second home is a great investment goal. But as you comb through the Web for your dream locations and prepare to make a down payment, consider the practical financials of owning a second home.
Is this a short-term rental opportunity or true second home?
Usage and financial needs should determine the answer to this question, though most people have to rent their homes in order to get some tax benefits on their property.
Renting, of course, can generate income to help defray property costs, which could impact the price you are willing to pay. While it varies by location and rental marketplace, the potential additional income is not a bad perk to consider when buying your vacation home.
You will also have all sorts of additional expenses, like utilities, maintenance, repairs, upgrades, yard work, Homeowners Association (HOA) fees, and more. When looking to purchase a second home, you need to factor in all the costs of the home to determine affordability.
Before you buy, remember to think through how your usage options may impact the bottom line—whether that means renting the property for most of the year and only using it yourself on occasion, or using the property often and renting it out infrequently.
What are the tax implications of renting out the home?
If you rent out the home, you will have income tax on the net rental income, but second homeowners may also qualify for various tax benefits. This includes deductions for items like mortgage interest, real estate taxes, casualty losses, management fees, maintenance, utilities, insurance, and depreciation.
You may qualify if you rent your furnished property for more than 14 days per year. However, while all of your rental income is taxable, only a portion of your expenses—prorated for the number of days you rent out the property—may be deducted.
In addition, you may have to pay transient occupancy taxes, which are similar to those incurred by hotels. In some locales, the property may be taxed differently (perhaps at a different rate as a commercial property), depending on its rental use.
Keeping the accounting straight may seem tough, but you can work with a professional property management company to help keep you in compliance with proper accounting of income and the remittance of local occupancy taxes.
Who or what entity will own the home?
Think through the implications of each of your options for title ownership and what’s best for your individual situation. Some options include:
The property is in your name: Growing your estate with the addition of a second home could change your estate plans, if that’s a consideration for you. Keep in mind that, in 2021, if you pass on total assets worth less than $11.7 million from one person, or $23.4 million from a couple, the estate is generally not taxable and free of federal taxes. Your taxable estate may be reduced through deductions, which might include items such as mortgages, estate administrative expenses, and property passed to a surviving spouse.
The property is a small business: If you create a limited liability company (LLC) for the property, which may be easily done through your accountant or attorney, membership interest can be transferred across owners more easily. Each LLC creates its own operating agreements, or rules, which are formulated to govern the property, its ownership, and all decisions pertaining to it. What this means is that if the LLC has multiple members, they must all agree to the same rules so there are no surprises. In addition, the LLC offers individual liability protection from potential issues. When structured to address an individual’s particular circumstances, high net worth individuals often find an LLC structure is preferred to direct ownership.
The property is in a trust: If you anticipate issues with future costs of ownership and decision disputes, a trust can preserve the asset and access to it by heirs. All you have to do is create a trust that holds title to the property, which may be done through your accountant or attorney.
What are my exit options?
Just like with any asset, you will generally be subject to capital gains tax when you sell your second property. Generally, that means that you are subject to a tax on the proceeds of the sale that are in excess of your cost basis.
There are a number of exceptions to the general rule. For instance, one major exception is if you convert your second home into a primary residence for two of the five years before you sell the home, you may be able to reduce your tax liability. You can only claim the benefit exclusion for one home at a time, however. As always, you should look at your overall position and perhaps always consult a tax professional expert before making any decisions.
Second home ownership can offer more than just a spot on the beach or the slopes; depending on how you manage your property, you could see it as a rental annuity stream with tax deductions. However, managing properties can also be taxing on your time and energy, so you may consider working with a professional management company to guarantee income upfront and take away the burden of finding and managing renters.
The bottom line is this: Be sure to think carefully through the implications of how you manage your purchase and your property, and consult your accountant and other professionals to maximize upside and ease for you and your family.
Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.
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