Consideration to Address before Buying a Second Home by Rick D. Bazzani, CPA
Posted on December 06, 2022
According to the National Association of Realtors, sales of second homes spiked dramatically during the first two years of the pandemic due, in part, to historically low interest rates and the ability to work remotely from anywhere in the world. Today, even as home sales have slowed slightly, purchasing a second home for personal enjoyment, passive rental income or both must be executed very carefully to avoid a series of potential tax traps.
Before buying a second home, consider how you plan to use the property both in the short term and in the future. For example, if you expect to one day retire to that residence, you should consider whether its features will allow you to live there safely, independently and comfortably as you age. Similarly, the home’s location and proximity to life’s necessities, such as medical care, grocery stores and restaurants, will become more important as you get older and ultimately affect the property’s resale value when it comes time to sell. These factors, along with recent home sales and rental rates, are also important when you plan to use the property for investment purposes.
Know What You Can Afford
When considering the purchase price of a house, condo or townhouse, remember to include the carrying costs you will incur for property insurance, property taxes and home maintenance, including lawn service, alarm systems, minor repairs and homeowners’ association fees. Equally important, you should consider the age of the home and the likelihood that you will need to replace big-ticket items, such as a roof, air conditioner, water heater or large appliance during your time as an owner. Depending on the location and intended use of a second property, you may also have to hire a handyman or house sitter to check in on the home, manage on-site issues and prepare it for a new tenant or your arrival in the case of a vacation home.
Consider Your Lending Options
In most cases, mortgage lenders have stricter lending requirements for buyers purchasing a second home than they do for a primary residence, regardless of whether the property is used for personal enjoyment or investment purposes. For example, lenders often require borrowers to have a lower debt-to-income ratio and pay a higher down payment and higher interest rates to secure a mortgage on a second home. To avoid some of these restrictions, consider a cash purchase or use an existing line of credit.
Know your Federal and State Tax Liabilities
The state where your home is located can provide certain tax benefits. For example, residents of eight states only pay income tax at the federal level. They are Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming. The remaining states and the District of Columbia impose some form of income tax on their residents at rates that can range from less than 1 percent to more than 13 percent.
If you itemize your deductions on your federal income tax returns, you may be able to deduct up to $10,000 each year in state and local income tax, real estate tax and personal property tax paid to the jurisdiction where you have established residence. Itemizers may also deduct as much as $750,000 in mortgage interest they paid on a secondary home used for personal purposes and purchased after Dec. 15, 2017. For primary and secondary homes purchased between Oct. 14, 1987, and Dec. 16, 2017, the maximum allowable mortgage interest deduction is $1 million.
Different tax rules also apply depending on your use of a secondary home. Generally, you must report on your personal tax returns all income you generate from rental property unless you use that property as a home and rent it out for less than 15 days during the tax year. If your sole intent is to earn a profit, you may be able to reduce your taxable income by some of the expenses you incur operating the property, including mortgage interest, real estate taxes, casualty losses, maintenance, utilities, insurance, and depreciation. However, you may not deduct rental expenses that exceed your gross rental income, less mortgage interest and real estate taxes for the portion of the rental period.
Purchasing a second home is a decision that should be made with advanced planning under the counsel of experienced advisors and accountants. Doing so will help homebuyers maximize available opportunities and avoid a tidal wave of potential problems down the road.
About the Author: Rick D. Bazzani, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides individuals and entrepreneurs with a broad range of tax-efficient estate, trust and gift-planning services. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or email@example.com.