A second home can create a family tradition, become a beloved gathering place, and potentially even a legacy to hand down to the next generation.
It can also create significant complications for your annual tax filings as well as your family's estate plan.
Given that, it's important to consider all the tax implications of a second home purchase, from deductions to property taxes and capital gains. "Buying a second home is an exciting decision," says Nicholas Ashjian, an advanced planner with Fidelity. "But putting emotion temporarily aside and looking at things from a tax standpoint can be very helpful to avoid unforeseen obstacles in the future."
Investigating the full picture before you buy could help ensure that the property provides the experiences you desire without disrupting your other financial goals, Ashjian adds. Here are some considerations to discuss with your tax advisor before making the leap.
Tax deductions for second homes
Property taxes: "These may be tax-deductible, but within limits," Ashjian notes. Since passage of the 2017 Tax Cuts and Jobs Act (TCJA), taxpayers may deduct up to $10,000 in state and local property taxes per return (or $5,000 for married couples filing separately). So if you're using all of that deduction on your primary home, you may not be able to deduct on the new one, unless you plan to make it a rental property. (See "Tax implications of a rental property" below.)
Mortgage interest: Thanks to the TCJA, mortgage interest deductions max out at $750,000 of total debt for taxpayers (or $375,000 each for married couples filing separately). "As with property taxes, that includes your primary residence plus any other non-investment properties," Ashjian says. If you're buying a second home for personal use, you may be eligible for little or no federal mortgage interest deductions on the second home depending on how much of your deduction limit you're already using for your primary home.
Capital gains: When you sell your primary residence, married couples can exclude up to $500,000 in gains (or $250,000 for individuals or married couples filing separately) from capital gains taxes. For a second home that you have not lived in as a primary residence, that exclusion doesn't apply, Ashjian notes, so if the value of the second home has appreciated, you'll owe capital gains tax on the difference between the purchase price and the sale price when you go to sell it.
However, if you spend more than half of the year in the second home, it could qualify as your primary residence. If you do that for 2 out of 5 years preceding the sale of the home, you may be able to apply your primary residence capital gains exclusion to the sale. If you plan to sell your second home in a few years, and expect a sizable gain on the sale, one strategy to consider and discuss with your tax advisor could be to qualify the second home as your primary residence for 2 years before selling, Ashjian suggests.
Potential tax implications of a rental property
If you're planning to rent out your second home some or all of the time, the tax picture changes. You may be able to claim income tax deductions on mortgage interest, property taxes, insurance premiums, utilities, and other costs, as well as annual depreciation. The amount you may be able to deduct depends on how much you use the home yourself versus renting it.
The IRS considers a "dwelling unit" (such as a house or apartment) a residence if you use it for personal purposes for a number of days during the tax year that's more than the greater of 14 days or 10% of the total days you rent it to others at a fair rental price. If the dwelling unit is a residence, there are limitations on how much you can deduct. There is also a special rule that states if you rent a residence for fewer than 15 days, you don't report any of the rental income and don't deduct any expenses as rental expenses.
If you are using the home as both a residence and rental, you'll need to divvy up the total expenses by the number of days used for each purpose. For example, say that renters occupy the house for 50 days while your family is there for 150. Since rental time accounts for 25% of the total days used, you get to deduct 25% of expenses (see chart below).
How a second home may affect your estate plan
If you'd like the vacation home to be a family legacy for generations to come, it's important to consider potential estate tax implications, Ashjian says. Unless Congress passes future tax reform, the current lifetime gift and estate tax exemption ($12.92 million per individual, or $25.84 million for couples in 2023) is scheduled to drop by about half in 2026. Depending on the size of your estate, an expensive vacation property could generate significant estate taxes or potentially cause a liquidity issue if an estate tax liability becomes due.
Transferring ownership of a primary or secondary residence out of your estate and into a qualified personal residence trust (QPRT) is designed to help mitigate estate taxes down the road, Ashjian notes. Though transferring ownership counts as a gift for federal gift tax purposes, the value of the gift is reduced by the fact that you reserve the right to live in the home after the initial term of the QPRT ends. Because of the way the gift is calculated, QPRTs actually work more efficiently in a higher interest rate environment due to a larger reduction in the value of the initial gift—hence, they've recently become a more popular strategy to consider for those looking to leave real estate to heirs as a legacy asset, Ashjian says.
With QPRTs or any other tax issue, there are trade-offs and the rules can be complex, Ashjian cautions. Consult your tax advisor before making any decisions. Your financial professional can also help you determine how the purchase of a second home fits with your overall finances—or whether you'd be better off renting someone else's dream home for a few weeks a year.