The summer travel season is in full swing and many of our clients are headed to their favorite destinations along the Florida coast, Colorado Rockies, or abroad.
For those with similar aspirations to own your favorite getaway, we thought it would be timely to share five budgeting and tax tips to keep in mind before making the leap to ownership.
Recent tax law changes have impacted the deductibility of property taxes. Previously, clients could deduct the full value of property taxes on their primary residence and vacation home(s) when itemizing their deductions.
Today, however, state, local, and property taxes are limited to a combined $10,000 of deductible value, which means you may not be saving as much as you think on taxes when buying your next home.
Tax law has also changed the math on mortgage interest deductibility. Going forward, this limits mortgage interest deductions to the first $750,000 debt used to purchase a first or second residence.
Clients with an existing mortgage, or those looking for financing an excess of $750,000, may be unable to deduct the full value of their annual interest payments.
For example, a client who finances their vacation home with a $1 million mortgage at 5% interest could only deduct ¾ ($37,500) of the annual interest paid instead of the full $50,000.
What if you grow tired of the maintenance and hassle of owning a second home and decide to sell? You should note that the sale of a second home is not afforded the same tax exemption available when selling your primary home.
For married couples filing jointly, $500,000 of gain (profit) on the sale of your primary residence is exempt from capital gains tax. However, any gains resulting from the sale of your vacation home do not qualify for the same exemption.
The tax rules that apply to rental properties are very different from those that apply to one’s personal residence. Many second homeowners choose to rent their vacation home to help pay the bills or supplement their existing income. The owner of a rental property can deduct depreciation on the home when filing their annual taxes, thus lowering the income tax payments on the rental income they receive.
However, it’s important to note that depreciation also lowers the adjusted cost basis of the property when the owner decides to sell, thus increasing their capital gain (and the taxes they pay) as a result. If you’re considering a purchasing a second home to serve as a rental property, you should first understand that the gains attributable to depreciation from renting your vacation home will be taxed at your marginal tax rate when sold.
For example, if you purchased your vacation home for $1.2 million and the depreciation of your property amounted to $325,000, the adjusted cost basis of your home would be $875,000.
| Purchase price | $1,200,000 |
| Depreciation | $325,000 |
| Adjusted Cost Basis | $875,000 |
| Sale Price | $1,500,000 |
If you sold your secondary residence for $1.5 million, the recapture gain (taxed at marginal income tax rates) would be $325,000 and the realized gain (taxed at capital gains rates) will be $300,000.
While taxes are an important part of deciding if a second home is right for you, it’s even more important to consider the additional costs and time needed to maintain the home while you’re away. The dream of owning a turn-key property can quickly become a nightmare if you’re constantly funding repairs and spending well-deserved vacation time keeping up with your new home. To set expectations ahead of time, we recommend budgeting ten percent of the property value every year for repairs and maintenance.
Like all other aspects of financial planning, planning to buy a second home requires that you consider all aspects of your long-term financial plan across every stage of your retirement journey. However, this isn’t always easy to do considering the complexity of the recent tax law changes paired with the variability of financial planning from one person to the next.
Always remember that a one size fits all advice is likely to put you in an uncomfortable place later down the road, which is why you should always get a second opinion from a trusted advisor before making such a significant financial commitment.
If you’re considering the purchase of a second home but are unsure how it may affect your long-term financial plan, schedule a conversation with a Willis Johnson & Associates financial professional to learn more about what you should consider.