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.
Query: Did the adoption of this tax rule in 2009 contribute to the decline in the value of vacation homes around that time? No one can say with certainty.
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 there is an intention to keep the vacation home in the family, a Qualified Personal Residence Trust (QPRT) should be considered. One can think of this as a major gift scheduled for a future date. The home is placed in a special trust that lasts for a specific number of years. The homeowner retains the right to live in the home for the full duration of the trust, and the children (or other beneficiaries) receive the home when the trust terminates.
The home transferred to a QPRT must be a personal residence, but it does not have to be a primary residence. Vacation homes and associated property, for example, are eligible for this estate planning strategy. And the trust may include other structures on the property if they are suitable for a personal residence, taking into account the neighborhood and the size of the house.
A gift tax return will be required when the home is placed in the QPRT.
However, the value of the gift will be discounted to reflect the delay until the gift takes effect. The discount can be very substantial, and it is a function of the current market interest rates as well as how many years will elapse before the gift takes effect.
For the strategy to succeed, the owner must survive to the end of the trust term. But if the owner dies during the trust term, the estate is in no worse position than if the QPRT had not been undertaken.
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