Winter's deep freeze has Americans dreaming of summer homes, but advisors warn of risks

With much of the country stuck in a deep freeze, a lot of Americans are dreaming of buying a second home in a warm climate or perhaps stepping up to a bigger summer home.

Their financial advisors, however, say they may want to chill out before making a big move on a second home because it takes careful planning to ensure that the property doesn’t derail tax and legacy planning. As enticing as they are during the winter months, second homes introduce significant planning considerations for the owners and can also become a tricky part of an inheritance down the line.

Adrian Larson, regional director and partner at EP Wealth Advisors, says the first question that needs to be considered is what the purpose and usage of the second home is going to be. If it is merely going to be a second home then it shouldn't change anything from a tax standpoint. As long as it is not being used as a rental, then mortgage interest and property taxes are all deductible to the same limits as a first home.

Where the tax issue comes into play is if the second home is rented out, according to Larson. If it is rented for 14 days or less in a given year, then the rental income is completely tax-free. But if you rent it out for more than 14 days, all the rental income must be reported. Also, a second home, unlike a primary residence, does not allow for any capital gain exemption, so any gain in the value of the property is going to be fully taxed at capital gains rates when it is sold. 

“This means that tax and estate planning must be implemented prior to sale to be able to limit or defer capital gains taxes either for the first owner or for heirs after the death of the original owner. The potential use of strategies like 1031 exchanges can allow owners to diversify their real estate holdings while deferring capital gains taxes until the first death, which allows for the step-up in cost basis,” Larson said.

Tom Evans, wealth strategist at RBC Wealth Management, agrees that there is more to buying a second home than finding the right location. He points out that the family will want to think about how they intend to use it, who will own it, and how they will finance the purchase.

“The way the family structures ownership can affect estate planning and what happens to the property when it is passed on to heirs. Location matters too, a property in another state or country may have unique tax considerations or inheritance rules. Most importantly, the family should carefully think about their family dynamics and long-term goals,” Evans said.

Elsewhere, David Handler, partner in the Trusts and Estates Practice Group of Kirkland & Ellis LLP, says the buyer needs to consider who will be the owner, whether it be one spouse, both spouses, or perhaps a trust for the children. He adds that the purchaser should also consider implications at death, like whether it should be sold or pass in equal shares to the children. Furthermore, he advises buyers to consider owning it through a revocable trust to avoid probate.

“I can’t advise on whether a second home would be a good investment.  Homes generally are not investments; they are assets for enjoyment that cost a lot to maintain. If they appreciate in value, all the better,” Handler said.

UNDERSTANDING THE MARKET

Whether this is going to be a vacation property for the family or an income-generating property, potential buyers need to understand the pricing dynamics of the local market, the potential rental rates one can get for similar properties in the area, and also the annual maintenance costs owners can expect to pay. 

“If buying in an unfamiliar location, state, or country, it’s a good idea to take an extended vacation in this area. Focus on doing the activities you enjoy. If you discover you continue to go to the adjacent community for your activities and enjoyment, reconsider your location,” said RBC’s Evans.

Stressed Evans: “Understand the ongoing expenses, property taxes, HOA fees, maintenance expenses and tax implications, including mortgage interest deduction, rental income tax, capital gains underlying ownership expenses.”

He also recommends discussing the purchase with the entire family if the intention is to purchase a property to be enjoyed and used by them.

“It’s better to know how everyone in the family intends to use the property before you buy to avoid conflict,” Evans said.

LOOKING TO THE FUTURE

As to how second home-owners can prepare inheritors to manage it in the future, EP Wealth’s Larson says it makes sense to “begin with the end in mind.” 

“Although second homes can be a great asset for future generations, many times, individual family members have their own financial issues that push them to want to sell the real estate they inherit. Siblings can find themselves in conflict if their financial situations are different,” Larson said.

Additionally, he points out that sentimental forces can cause heirs to hold on to properties that they are not utilizing, thus sacrificing the potential for the capital to be redeployed into faster growth areas.

Finally, Evans encourages clients to coordinate the succession of a second home with their overall estate planning. That means considering the ownership of the second home now and how it will change after the death of the owners. 

“Prepare a plan that prevents financial burdens, minimizes conflict, and ensures a smooth tax efficient transition to your heirs or others. Engage family members in discussion to determine their commitment level to engagement and desire to manage, use, and maintain the property. And create a family mission statement to align the generational interest and intent,” Evans said.