End of the Year Tax Planning: Time for a Second Home?

We met with our CPA to see what, if anything, we could do for 2010 taxes. Turns out the ATM fixes it so that many people cannot deduct property taxes, and Texas, unfortunately, has some of the highest in the land. (Alas, we do not have a state income tax, at least not yet.) We can still deduct home mortgage interest on first and second homes, but those days may be numbered. So it appears that this year and next may be the best time ever to buy a second home.

Then hunker down for God knows how long.

Why should you consider buying a second home? First the “F” words: Finances, fun, family and the future. A rental property, once it is paid off, provides monthly cash flow. A vacation home can be loads of fun and relaxation, a nice getaway spot for you and your loved ones where you have a twinge of familiarity, build memories and develop new friends. Many people buy property for family members, too, including investment buildings that are rented out and later sold when the heirs come of age. One Dallas Realtor swears to buying a duplex to finance college years: you live on one side, lease the other, then sell the unit when you need the cash for college. Some of us may consider buying a second home for our golden years — mine will be more platinum, darling — locking in a future retirement home at today’s prices and historic low interest rates.

According to the National Association of Realtors, in June 2010, the median national price for an existing home averaged about $180,000. And second homes were not much higher. The average second home buyer is not a millionaire: they make about $150,000 a year.

Of course, purchasing a house is a huge financial commitment, and one that shouldn’t be taken lightly. So here are some pointers to keep in mind if you do decide that a beautiful beachfront residence or a mountain home is in your future.

Location: Water or Hills

We’ve all heard the real estate maxim that location is everything, and it is even more vital when it comes to buying a second home.

Nobody buys property with the expectation that it will decline in value, and we all want to jump in on the sweet spot. Unfortunately, we have seen proof that is not always possible. In a word: Phoenix. To maintain maximum values, buy in popular areas, near beautiful natural resources, near beaches, lakes or mountains. Aspen: that place will never decrease in value.

(I know, Phoenix has mountains.)

And think globally when it comes to second-home opportunities, especially if you’re considering a home for retirement. A huge ex-pat community is growing in Merida, Mexico, near Cancun, Yucatan Peninsula where I’m told it is safe and units are moving.

Chad Martin, who conducts global real estate research for E-360 Consultants, recently returned from a trip to Merida and was amazed to see the sale of homes in the area: almost like 2005. They are moving, he says, three to seven units a month in Merida.  In the rest of Mexico, developers are lucky if they move one or two units a month.

“This is such an affordable second home market,” says Chad, who was also at Isla Mujeres where he observed a  $700,000 cash transaction for an upcoming developing on that pristine little island visible from Cancun where I have swum with the dolphins.

“Ilsa is getting ready to pop,” says Martin. “True island living  — all sandy bottom floor restaurants — very authentic, native, gorgeous.”

Another undiscovered gem he is hearing more of that we will be watching for you on Second Shelters: the colonial (1540) city of Campeche.

Despite the problems  — yes, Mexico is very scary in some parts — many Americans can find affordable beach front property there for a fraction of what they could buy in the U.S.

Some of the world’s most affordable housing markets — including Canada, the Caribbean and Central America – are all relatively close to the U.S., yet dramatically cheaper. That fact, combined with growing American angst about everything from job security to social security, means that more pre-retirees (in particular) are expanding their real estate horizons. Last week I had lunch with the developer of Caye Winds, Belize. The prices sounded unreal: 7500 square ft. home for $1.5, and all homes staffed. Beachfront condos start at about $450,000. The developer is sinking $50 million into phase I, $450 million into phase II and will include a marina. I will get down there this spring and check it out before we endorse one stick.

Piti-ful Deductions

Cost is obviously your major consideration when contemplating a second home. Mortgage rates are low, but can you really afford it? Is it worth skipping a weekly steak dinner to have a second home? Most couples find it easier to do this once the kids are grown and educated; others like to begin early, calling it an investment in their families’ future.

Mortgage interest rates are at historically low levels, but interest rates on second homes typically run about half a percentage to a full percentage point above rates for your principal residence. If you buy in a foreign country such as Mexico, where more people pay cash for their homes, rates will be higher. Insurance costs can be higher too, particularly if you buy a vacation property in a hurricane-prone locale, such as Florida. And don’t forget those pesky property taxes that may not be deductible if the ATM hits you.

With a second home, however, you’ll need to think well beyond the principal, interest, taxes and insurance parameters. If you buy a second home, be prepared to pay for:

• Advertising for renters/realtor commissions
• Appliances and repairs
• Carpets, flooring and rugs: they wear out more rapidly in a vacation home
• Fees to a landlord or professional property manager
• Furniture: casual, comfy, but sturdy.
• Gardening supplies: if you have a yard.
• Home improvements (additions, renovations and upgrades)
• Lawn care: if you have a lawn.
• Lighting fixtures: use long lasting lightbulbs, and pray tenants don’t steal them
• Maintenance: always
• Moving costs:
• Repairs and extermination
• Supplemental insurance (earthquake, flood, hurricane or tornado coverage)
• Utilities
• Window treatments

These are the hidden expenses that create true  home ownership — the initiation fee! Experts recommend stashing away at least 2 percent of your home’s value as a cushion to pay for the items above without going into debt.

Don’t Forget the Tax Man

If you plan to rent out your second home, you’ll have to adhere to strict IRS rules in order to reap the tax benefits from your real estate investment. Tax laws concerning second homes are complicated, so you’ll definitely want some professional advice in this area.

First off, there’s the capital gains exemption. With your primary residence, you are allowed to exclude up to $250,000 in capital gains when you sell your house. The exemption is even larger ($500,000) if you are married. Unfortunately, that same capital gains exemption doesn’t apply when you sell a vacation home. To get the tax break, you’d have to make that vacation property your primary residence for at least two years.

The new health care plan will also be taxing those capital gains at about 4%.

If you rent out your home for 14 days or less, you do not have to report the income from the rental to the IRS. Rent it out for more than 14 days, you do. The downside, though, is that you can’t write off any expenses you might incur for renting out your property.

If you rent out a second home for more than 14 days, you are legally permitted to deduct expenses. You can only use the home for personal reasons for no more than 14 days a year, or if at least 10% percent of the total rental days are for personal use.

As with most things tax-related, IRS rules can get complex, and are ever changing, so be sure to enlist the services of an accountant to minimize your tax burdens – and stay on the right side of the law.

Our CPA surprised us with the news that we are free to sell our investment property in San Antonio this year, without having to worry about taxes. I plan to do a 1031 Exchange with the property and think this may be the year to get my own little place at the beach. I can hear the waves washing on the shore already!