Presented by Stewart C. Parmele, CPA
Dear clients and friends,
If you are considering buying a vacation home, you are in the prime season to shop. Unlike traditional home sales, which tend to slow down with the colder weather, fall and winter are the prime seasons for buying and selling “snowbird nests.”
Rent or Buy?
The first thing to consider is whether it makes more sense for you to rent or to buy. Most people plan to use their vacation home for personal vacations. If that is your motive, then consider realistically how much you’ll use it and whether you will want to return to the same site year after year. Other buyers plan to use their vacation homes as their primary residences when they retire. If that is your motive, evaluate the location’s medical care facilities and wheelchair/walker accessibility. Also look carefully at the features of the home itself. Is it “senior friendly?” Big yards, stairs and pools may be too much for senior homeowners to manage independently. Will this home and location serve you ten or twenty years down the road? Another reason for buying a vacation home is the investment potential: monthly rental income, as well as price appreciation. Further down in this article, we will discuss the tax ramifications.
Location! Location! Location!
The next thing to consider is location. If your vacation bungalow is too far from your primary residence, the cost of airfare or gas may discourage you and other family members from making use of it. The property me be underutilized and maintenance may be neglected. If this will become your primary residence in retirement, is it located near enough to children and grandchildren?
In considering how much you can afford, don’t forget the hidden costs. For example, while typical homeowners insurance will cover damages from fire, theft, and vandalism; because of their locations — often near beaches and mountainsides — vacation homes may require special insurance coverage for location-specific risks, such as hurricanes and floods. Many vacation home communities charge association dues, especially if they have a pool, golf course, or other ammenities. Property maintenance and management will also need to be figured in. Some vacation home owners pay a professional property manager (or a neighbor) to look after the property and help with renters while they’re away. There are also home watch companies, which regularly visit and inspect properties. Other ongoing maintenance expenditures include structural repairs, utilities, landscaping service and cleaning service fees.
If you use the vacation home strictly as a second home, not a rental property, and you itemize deductions on your personal tax return, you can generally deduct interest expense on up to $1.1 million of debt to acquire, build or improve your first and second homes combined. This includes acquisition debt and home equity loans on these properties. You can also deduct property taxes on both homes, if you itemize deductions.
If you use the property for both rental and personal purposes, you generally must divide your total expenses between the rental and personal use based on the number of days used for each. However, you will not be able to deduct your rental expense in excess of the rental income limitation. This amount generally equals your gross rental income less the rental portion of mortgage interest and real estate taxes. You may be able to carry forward some of these rental expenses to the next year, subject to the gross rental income limitation for that year. If you itemize deductions, you may still be able to deduct your personal portion of mortgage interest, property taxes, and casualty losses on that schedule.
If you rent for more than two weeks during the year, you need to report the rental income on your personal tax return. However, you may be entitled to deduct certain expenses. These expenses — which may include mortgage interest, property taxes, casualty losses, maintenance, utilities, insurance and depreciation — will reduce the amount of rental income that’s taxed.
Selling Your Vacation Home
When you sell a home, IRS rules allow an unmarried seller of a principal residence to exclude from federal income tax up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. To qualify for this tax break, you generally must:
- Own the property for at least two years during the five year period ending on the sale date, and
- Use the property as a principal residence for at least two years during the same five year period.
To be eligible for the maximum $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test. Additionally, if you excluded gain from an earlier principal residence sale, you generally must wait at least two years before taking advantage of the gain exclusion deal again. If you are a married joint filer, the $500,000 exclusion is only available if neither you nor your spouse claimed the exclusion privilege for an earlier sale within two years of the later sale.
Some retirees sell their principal residence and move into their vacation homes. But a gain on the sale of a vacation home that’s become a principal residence may not qualify for the federal home-sale exclusion — even if you’ve lived there for at least two of the last five years. Any period of time beginning in 2009 where you don’t use the vacation home as a principal residence is considered a period of “nonqualified use” and will require you to recognize a portion of the gain when you sell the property. The amount of the gain that’s subject to federal tax will be based on the ratio of time after 2008 that it was a second home or rental property (the period of nonqualified use) to the total period of ownership.
Owning a vacation home can be a reward for years of hard work and a great legacy you leave for future generations. Give us a call for additional guidance on this important decision.
Very truly yours,
Stewart C. Parmele, CPA
Daniel A. Kosmatka, CPA, PFS, CFF, CGMA
Robert W. Hague, CPA
Dennis W. Donnelly, CPA, PFS
Mark E. Damon, CPA
Michael R. Gohde, CPA, PFS