More clients are purchasing vacation homes — a trend which can translate into more work, but also more opportunity, for full-service advisors.
According to the National Association of Realtors, last year saw 445,000 purchases of second homes in the United States, a 25 percent increase over 2001's figures.
Logic says that the people buying these homes have a decent chunk of disposable income and are thus desirable financial services clients. For this reason, it's to an advisor's advantage to have some idea of the tax implications of a client's purchase of a second home.
Unlike primary residences, many second homes are also used as rental properties to generate income. This money may be used to simply defray property taxes and maintenance costs, or as an ongoing stream of income for retirees. In either case, the tax code regarding vacation homes can be complicated. Certain rules apply to the income one receives from renting the home and the expenses they incur from maintaining the home.
How the income and expenses are treated depends on whether the property is considered a second home or a rental property for tax purposes. This is determined by examining the number of days and the respective usage of a property.
If a property is used personally for the greater of 14 days or 10 percent of the total days it is rented (at a fair rental price), it is considered a personal residence.
Property used as a home and rented fewer than 14 days = Personal Residence
When a home is not rented for more than 14 days a year, it is not considered to be a rental at all. As such, property taxes and mortgage interest are typically 100 percent deductible (subject to various limitations) and any rental income does not need to be reported and is not taxed. The downside: other deductions, such as maintenance and depreciation write-offs are not permitted.
From a tax perspective, this can be quite a boon for clients with properties that can be rented at an exorbitant rate for short time periods (i.e., properties located near a major golf event, beach/ski resort or the Super Bowl), as the rental income is completely tax-free.
Property used as a home and rented more than 14 days = Personal Residence
If, however, the property is rented for more than 14 days and personal use exceeds the 14 days a year (or 10 percent of the total rented days, if greater) the property is treated as a personal residence. Therefore, the rules state that, generally, rental expenses are deductible on Schedule E of form 1040 only to the extent of rental income (i.e., “zero-out the rental income”). Since the property is considered dual purpose, any excess rental deductions may be carried forward to future years and will be deductible up to rental income in the following year. This means that an owner cannot report a loss on their 1040 and offset other income.
The allocable rental expenses are deducted from rental income in a specific order, starting with the allocable part of interest and taxes. Operating expenses come next, followed by depreciation on the rental part of the residence. Remember that this property is also considered a personal residence. Therefore, the balance of the allocable portion of interest and real estate taxes can be deducted as an itemized deduction on Schedule A of form 1040 (subject to their specific limitations).
Keep in mind that the IRS limits people to two homes regarding their mortgage interest deduction. If the client happens to own more than two homes, interest payments on those “extra” properties are not deductible. In such cases, the client should choose the vacation home with the largest total deductions for real estate tax and mortgage interest. Regardless of the number of properties owned, property taxes are typically 100 percent deductible.
Property not used as a home and rented more than 14 days = Rental Property
In this case the owner must report all rental income and expenses on Schedule E of Form 1040. Unlike when a property is a considered a home, the deductible rental expenses can be more than the gross rental income. However, a loss deduction is subject to the passive activity loss restrictions. In addition, the interest expense not allocable to the rental use is considered nondeductible personal interest.
Typically, the client can deduct passive losses in a tax year if there is passive income from other sources. There are exceptions to this rule based on other criteria, such as the client's adjusted gross income and their degree of “active participation.” Therefore, it's best to consult with a tax advisor to navigate the nuances of these rules.
Second Homes in an Estate Plan
Second homes can also be a valuable estate-planning tool through the use of a Qualified Personal Residence Trust (QPRT). To establish a QPRT, the residence is transferred to a trust that names heirs (usually a child or children) who will receive the property at the end of the stated term. Until the term is over, the donor generally lives in the house, and after the term, it usually rents at fair market value if they still want use of it. For tax purposes, the donor is still considered the owner and can take the tax deductions related to the property.
Because the donor is “retaining an interest” through the right to live there for the term of the trust, the current value of the gift for gift-tax purposes is discounted. The discount is based on the client's age and the length of the term of the trust.
In order to reap the benefits of the QPRT, the donor must outlive the term chosen to use the residence. If this does not occur, the gift is treated as if it was not originally made for estate- and gift-tax purposes and the residence would be included in the estate and priced at the fair market value.
By providing clients with input regarding potential vacation-home purchases you'll be demonstrating your value as their trusted advisor. As with any major financial transaction, you should analyze the purchase of a second home in light of the client's overall long-term financial goals, time horizon and risk tolerance.
You may also want to view second-home purchases as an opportunity to network with third-party professionals, such as CPAs, real estate agents and estate attorneys. In doing so, you could receive the names of a steady stream of perspective high-net-worth clients.