Monday, March 27, 2006
Second Homes--Tax Benefits and Potential Tax Pitfalls
Many people are buying a second home. They might do so to have a vacation home with the possibility of selling it at a substantial gain in the future. Another reason people buy a second home is to use it in the future as a primary home, perhaps in retirement. They might prefer to purchase the second home now to avoid the possibility of having to pay considerably more for it in the future.
What are the tax benefits and potential tax pitfalls in purchasing a second home? The first benefit is that the real estate taxes on a second home are deductible as an itemized deduction. However, a potential pitfall exists if the taxpayer is subject to the alternative minimum tax (AMT). Real real estate taxes are not deductible for AMT purposes.
The mortgage interest is also deductible as an itemized deduction on mortgage loans up to a maximum of $1,000,000 on loans used to acquire, construct, or substantially improve the taxpayer's primary home and the taxpayer's second qualified home. A refinancing of acquisition debt is considered acquisition debt to the extent that it does not exceed the balance before refinancing.
Another tax benefit for owning a second home is that the taxpayer may deduct interest on home-equity loans up to a maximum loan amount of $100,000. A home-equity loan is considered as an acquisition debt if the taxpayer uses it to make a substantial improvement to the primary home or second home. The loans may be secured by the primary residence and/or the second home. For tax purposes, a home-equity loan includes the excess of the balance of a refinanced acquisition loan over the balance before the refinancing unless the taxpayer uses the excess to make a substantial improvement to the home.
A tax pitfall is that the interest on a home-equity loan is generally not deductible for AMT purposes. An exception applies if the taxpayer uses the proceeds of the loan of the loan to make a substantial improvement to the property.
If a taxpayer rents a second home to a tenant for 14 or fewer days during the year, the rent income is not taxable. The taxpayer may still deduct the real estate taxes. The taxpayer may deduct the qualified mortgage interest as long as the taxpayer used the second home for personal purposes for a number of days that exceeds the greater of 14 days or 10 percent of the number of days the taxpayer rented the house to a tenant at a fair rental. If the taxpayer does not meet this test, the second home might be considered as rental property.
A potential tax pitfall on a second home is that any gain on the sale of a home that is not the taxpayer's principal residence is taxable. It would be taxable as a capital gain because a personal use asset such as a second home is a capital asset.
The exclusion of gain up to $250,000 ($500,000 on a joint return) on the sale of the taxpayer's home applies only to the sale of a home that that the taxpayer owned and used as the taxpayer's principal residence for at least two of the five years before its sale. A taxpayer may have only one principal residence at a time.
A good tax savings strategy would be for the taxpayer to sell the primary home and exclude the gain up to the limit. Then, the taxpayer would move into the second home and use it as a primary residence for at at least two of the five years before the taxpayer sells it. By doing so, the taxpayer could use the exclusion of gain provision on both homes. The potential to exclude the gain on the sale of both homes up to the limit using this strategy is a major tax benefit.
Another potential tax pitfall on owning a second home is that any loss on the sale of a home used as the taxpayer's residence, whether as a primary home or as a second home, is not deductible because the loss is on the sale of an asset used for personal purposes.
An individual should consider many factors before buying a second home, such as cost, convenience, and potential gain. The tax benefits and potential tax pitfalls are some other key factors to consider before buying a second home.
What are the tax benefits and potential tax pitfalls in purchasing a second home? The first benefit is that the real estate taxes on a second home are deductible as an itemized deduction. However, a potential pitfall exists if the taxpayer is subject to the alternative minimum tax (AMT). Real real estate taxes are not deductible for AMT purposes.
The mortgage interest is also deductible as an itemized deduction on mortgage loans up to a maximum of $1,000,000 on loans used to acquire, construct, or substantially improve the taxpayer's primary home and the taxpayer's second qualified home. A refinancing of acquisition debt is considered acquisition debt to the extent that it does not exceed the balance before refinancing.
Another tax benefit for owning a second home is that the taxpayer may deduct interest on home-equity loans up to a maximum loan amount of $100,000. A home-equity loan is considered as an acquisition debt if the taxpayer uses it to make a substantial improvement to the primary home or second home. The loans may be secured by the primary residence and/or the second home. For tax purposes, a home-equity loan includes the excess of the balance of a refinanced acquisition loan over the balance before the refinancing unless the taxpayer uses the excess to make a substantial improvement to the home.
A tax pitfall is that the interest on a home-equity loan is generally not deductible for AMT purposes. An exception applies if the taxpayer uses the proceeds of the loan of the loan to make a substantial improvement to the property.
If a taxpayer rents a second home to a tenant for 14 or fewer days during the year, the rent income is not taxable. The taxpayer may still deduct the real estate taxes. The taxpayer may deduct the qualified mortgage interest as long as the taxpayer used the second home for personal purposes for a number of days that exceeds the greater of 14 days or 10 percent of the number of days the taxpayer rented the house to a tenant at a fair rental. If the taxpayer does not meet this test, the second home might be considered as rental property.
A potential tax pitfall on a second home is that any gain on the sale of a home that is not the taxpayer's principal residence is taxable. It would be taxable as a capital gain because a personal use asset such as a second home is a capital asset.
The exclusion of gain up to $250,000 ($500,000 on a joint return) on the sale of the taxpayer's home applies only to the sale of a home that that the taxpayer owned and used as the taxpayer's principal residence for at least two of the five years before its sale. A taxpayer may have only one principal residence at a time.
A good tax savings strategy would be for the taxpayer to sell the primary home and exclude the gain up to the limit. Then, the taxpayer would move into the second home and use it as a primary residence for at at least two of the five years before the taxpayer sells it. By doing so, the taxpayer could use the exclusion of gain provision on both homes. The potential to exclude the gain on the sale of both homes up to the limit using this strategy is a major tax benefit.
Another potential tax pitfall on owning a second home is that any loss on the sale of a home used as the taxpayer's residence, whether as a primary home or as a second home, is not deductible because the loss is on the sale of an asset used for personal purposes.
An individual should consider many factors before buying a second home, such as cost, convenience, and potential gain. The tax benefits and potential tax pitfalls are some other key factors to consider before buying a second home.
