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By Peter Harris, CFP® – Vice President & Portfolio Manager
As the fall arrives, you may very well be winding down the season at your beloved vacation home. For others, you may find yourself not using a vacation home quite as much as you had dreamed. Unfortunately, the last recession took a toll on the value of vacation homes. The National Association of Realtors reports that, from the end of 2007 through 2012, when primary homes were dropping in value by 14.8%, the value of vacation properties fell by 23%. The good news is that prices have come back strongly. The median price of a vacation home rose 28% in 2015 and another 4.2% in 2016, reaching $200,000.
The main reason for owning a vacation home is—or should be—for rest and relaxation. The vacation home also may serve as a “tryout” for a destination for retirement living. In some cases, it may become the home one retires to. But vacation homes have investment and tax angles to consider as well.
Rental income from the property may help cover some of the expenses of maintenance and improvement. If the property is rented for 14 or fewer days, the income is tax free. Rentals for longer periods may be offset with income tax deductions for mortgage interest, property taxes, insurance premiums, utilities, and other expenses, but the biggest tax benefits are available only to owners who use the property for 14 or fewer days during the year.
When it’s time to sell
The $250,000 exclusion from capital gains ($500,000 for married couples filing jointly) for the sale of a principal residence does not apply to the sale of a vacation home. At one time, it was possible to get around this rule by selling one’s principal residence and moving into the vacation home, living in it as the principal residence for at least two years. At that point a new exclusion would become available. This strategy was curtailed, beginning in 2009. Now the exclusion is not available for the portion of your ownership attributable to vacation home use.
Example. You bought a $1 million vacation property in 2010. In 2017, you sold your primary residence to begin living in the vacation home. Now assume that you decide to sell that home in 2020, after living in it for three years, when it is worth $1.5 million. That period is 30% of your total ownership, so only 30% of your gain of $500,000 ($150,000) is excludable from income. The same dollar limit of $250,000 also applies.
Estate planning
The issue of capital gains taxes evaporates if ownership of the vacation home continues until the death of the owner. At that moment, the tax basis of the property steps up to fair market value, so there would be no capital gain on a sale soon after.
If estate taxes are a potential issue, a Qualified Personal Residence Trust (QPRT) should be considered. In any event, when planning your estate, make sure to address the ownership of any vacation homes you own. Different planning methods may need to be considered depending on the state in which they are located.
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