Buyer’s Remorse
Assess the Ultimate Goal
Usually when you ask clients whether they plan to buy a second home for pleasure or investment, the response is “pleasure.” The follow-up questions should then be: “How long do you anticipate owning it?’ Then, “What, if any, growth rate do you expect on the value of the home?” Very rarely are there “rational” responses like “20-plus years” and a “5% or so return” (which is the approximate national residential 20-year average rate of return for a home).
Many buyers anticipate that the value of their second home will double, even though they say it is not an investment.
Often clients will buy on emotional and perhaps irrational factors. They will also base their decisions on some misguided information or misinterpreted facts. The following are some of the more common misconceptions:
A vacation home is a vacation home. A vacation home can be categorized in three different ways: personal, rental, and dual purpose. The one that pertains to your individual circumstance will depend on the days used and the days rented.
I always can deduct my mortgage interest on my second home. With so many affluent clients purchasing McMansions these days, it is not uncommon to see a large mortgage on their primary residence. Remember that you can generally deduct qualified residence interest on up to $1.1 million of home mortgage debt ($1 million worth of acquisition debt on up to two homes plus $100,000 of home equity debt on up to two homes). Any excess interest on home mortgage debt is generally nondeductible. Furthermore, the owner’s overall interest deduction may be lessened due to the itemized deduction phase-out rule for higher-income taxpayers (for 2007 the AGI level is $156,400). This rule is expected to sunset by 2010. As such, if nothing is done, in 2011 it will revert back to full phaseout. (Now there are legal methods that we use with our clients that allow them to deduct interest on well above the $1.1 mm limit).
I always have to report rental income. Rental income is completely tax-free for property that meets the rules for personal-use property, but has a very limited opportunity to generate rental income (generally 14 days or less). From a tax perspective, this can be quite a boon for clients with properties that can be rented at an exorbitant rate for a short time (e.g., properties located near a major golf event, Olympics, or Super Bowl location).
Vacation home donations are always a good idea. Unfortunately, the IRS considers vacation home donation days as personal use days, not rental days, since the owner did not receive a fair market rental for the use if the home. In addition to not qualifying for additional rentals expenses, the owner receives no charitable deduction for donating the use of the home to charity.
I can use the capital-gains tax exclusion ($500,000) upon sale. The exclusion applies only to principal residences.
A 1031 (tax-deferred) exchange can be done on a vacation home. A recent Tax Court ruling (Moore, T.C. Memo 2007-134) disallowed tax-deferred treatment for a personal vacation home. The court held that a couple’s exchange of vacation homes did not qualify for like kind exchange treatment because the homes were not held for investment purposes (as required by § 1031(a)).
Rental income will be offset by cost. With property prices still high, some clients may believe they will offset the cost of a second home by renting it. Unfortunately, clients forget that in order to cover their costs they often will have to rent it out at peak season, coincidently the weeks they want to use it the most.
This is a “business.” Many people say they manage their property and thus “materially participate.” In other words, they are in the business of renting real estate and are able to take losses against other taxable income.
You can go home again. And, finally, do not “impulse buy” while enjoying a vacation. If you have an interest in purchasing real estate at a great place where you vacationed last month, I suggest that you hold off until you have “felt out the neighborhood” for a while, meaning you should visit the location a few more times. You should focus on the commute to work, the community, people, activities, and amenities, and, very important, talk to as many locals as possible, particularly those who have owned vacation homes there for some time. Do you have a similar feeling of happiness each time you visit the location? Are your experiences consistent over time?
The financial ramifications as well as the emotional toll of purchasing vacation homes can be complicated. But understanding these rules and your expectations will open the door to some great discussions with your advisors.