Second Home or
Vacation Home Tax Benefits
Legal
Tax Angles:
How to
Save Taxes Without Going to Jail
Investing in a vacation
home offers the same basic tax benefits as owning your own
home. It isn’t the deduction for interest and taxes that makes
it a tax shelter. The major tax benefit is the value of the
use of the property on a rent-free and tax-free basis. Instead
of using your money to earn taxable investment income, you are using
it to provide vacation facilities that would otherwise have to be
paid for with after-tax income.
The investment of $50,000
in a lakeside cabin might be equivalent to an investment earning
about $4,500 tax-free. If it would cost $150 per night to rent
comparable facilities, the vacation home would have to be used at
least 30 days per year to generate that much in the way of
benefits. However, a vacation home can be rented for up to 15
days per year, and the income will be tax-free. So, if you use
the property only 15 days and rent it for another 15 days (at $150
per day), you would still receive a “yield” equal to 9% per year
after taxes.
In addition, you would be
likely to realize some substantial appreciation in the price of the
vacation home over a period of years, and any gain from the sale
would likely qualify as a tax-favored, long-term capital gain, at a
maximum rate of 15% if the property were not depreciated.
To the extent that a
vacation home is financed, the interest expenses are deductible in
the same way as interest on a primary residence. Any real
estate taxes are also deductible if you itemize your deductions. To
the extent that you rent the vacation home for more than 15 days per
year, the income and related expenses could be reported on Schedule
E and you could allocate a portion of the interest and taxes to that
schedule.
The tax law permits
homeowners to sell their principal residence without owing a capital
gains tax for the first $250,000 of gain. ($500,000 for a married
couple filing jointly.) The trouble with that tax break is that you
still need a place to live and you will end up using the money to
pay rent.
Consequently, the
$250,000/$500,000 tax free gain on selling your home is a mixed tax
benefit.
But ... there is a way to
get the full benefit of that tax break and to also end up with a
residence without a mortgage, when you retire. Use some of your
investment funds to buy a second home that will be adequate for your
needs when you are ready to retire. Buy the home in a location
where you want to live after you retire. That could be in the
same town where you live now, at the seaside, on a lake or in the
mountains. Make sure the home is also in an area where it will
be easy to keep it rented most of the time, with good quality
tenants.
If you don’t want to manage
the property yourself (or if it’s located out of town) locate a
reliable real estate management company or find someone you can rely
on to take care of the property for you - for a fee, or for a part
of the rental income. Buy the home with a mortgage if you need
to, but be sure that you will be able to make use of any tax
deductions and that you can afford to handle the debt payment
obligations if the property isn’t always rented. Then, the
tenants will help you to make the mortgage payments.
In about 15 to 25 years you
will have a second home that is all yours, with no
mortgage.
When you sell your current
residence and make the election to take up to $250,000/$500,000 of
gain tax free, you can move to your second home and use the exempt
income to increase your retirement income.
CAPITAL
GAINS
If you own some rental
property, you can convert the rental property into residential
property without having to pay taxes on the property. If your rental
property isn’t the kind you want to live in, you can do a tax
free exchange of the rental property before you convert it to
residential property.
With some careful planning,
you could swap a small office building for some rental residential
property and later convert that property into a retirement
residence.
INCOME
SHIFTING
Some parents I know had two
or more children who attended the same university at the same time.
These parents bought a small rental property near the university, in
which the children lived. After the last child graduated, the
house was sold. (It could also have been kept as an investment.)
Letting your dependents occupy a home without rent is not a taxable
gift. Of course, this tactic might not appeal to you if your
children are strongly motivated to join a fraternity/sorority or to
live in a college dorm. If
you do buy a residence for your college age children to live in, no
gift is involved unless you buy the residence in the name of your
children.
ESTATE AND GIFT
TAXES
If you have owned your
vacation home for more than ten years, it’s probably worth a lot
more than you paid for it. When you die, that untaxed gain
remains untaxed. The house is re-valued at the current market
value at the date of death. Any unpaid mortgage loans are paid
and deducted from the estate proceeds. In the case of a
jointly owned home, it’s almost treated as if there were two
properties. One half is re-valued as described above.
The other half retains the tax cost that it had. Thus, if a
jointly owned home cost $50,000 (including improvements) and was
worth $200,000 when you died, it would have a new tax cost of
$125,000 for your surviving spouse. That’s 50% of the $200,000
value at the date of death, plus 50% of the $50,000
cost.
The $250,000/$500,000 tax
free gain is wasted in the sense that the tax free gain and a step
up in basis isn’t available on the same residence. In order to
get the benefit of both, one residence must be sold to realize the
gain and a second residence must be purchased or obtained from the
conversion of rental property to personal use. Then the
second home can get a step up in basis at the time of
death. When a home is kept by a surviving spouse, part
of the potential tax free gain is reduced by the re-valuation
described above. If a home is gifted, the gift tax value is based on
the market value, but the tax basis to the donee is the same as the
basis to the donor. If any debt on the home exceeds the fair
market value of the home and the property is transferred by gift,
subject to the debt, then the donor will have taxable income to the
extent of any debt in excess of the value of the
property.
Related Articles
and Links
Vern Jacobs
Copyright, 2003
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