As the summer begins to wane, many people yearn for that feeling of tranquility and bliss they felt while vacationing at the beach or in the mountains...so much so that they seriously consider investing in a second home. According to Escapehomes.com, those who are driving the second-home market are over-40 consumers, active baby boomers nearing retirement, or speculative investors looking to flip properties for profit.
In other words, those contemplating a second home purchase may be many of your clients. Is this a smart move for them?
As students of investor behavior at JPMorgan Asset Management, we suggest that, before you do anything else, profile your clients to understand the motives behind this desire. As trusted advisors, your first order of business is to protect clients from their emotional selves. Have your clients thought through the numerous extras--beyond the great view or the quiet of the cabin in the woods--that come with adding a new property to their lives?
Clients' Behavioral Tilts
Are they being overly optimistic about how often they would use a vacation home? What are the chances that going every weekend or holiday to the same place would be of long-term interest to them?
Too often, vacation homes become a point of contention between spouses or parents and children. Are your clients being overly optimistic about the "legacy" that they want to leave their children? It's frequently the case that for adult surviving siblings the "family vacation home" becomes the cause of family fights and breakups as opposed to memories of happy, relaxing times together.
If you haven't done so already, now is a good time to discuss what your clients' current interests and lifestyles are and, more importantly, their ultimate goals.
Assess the Ultimate Goal
Usually when you ask clients whether they plan to buy a second home for pleasure or investment, the response is "pleasure." The follow-up questions should then be: "How long do you anticipate owning it?" Then, "What, if any, growth rate do you expect on the value of the home?" Very rarely are there "rational" responses like "20-plus years" and a "5% or so return" (which is the approximate national residential 20-year average rate of return for a home). Commonly, the time frame is something far shorter and the expected rate of return is something much greater.
Many buyers anticipate that the value of their second home will double, even though they say it is not an investment. Make sure you relay to them what the current market valuations are, what the long-term expectations may be, and how this second home would fit into their overall financial plans.
Often clients will buy on emotional and perhaps irrational factors. They will also base their decisions on some misguided information or misinterpreted facts. The following are some of the more common misconceptions:
A vacation home is a vacation home. A vacation home can be categorized in three different ways: personal, rental, and dual purpose. The one that pertains to your clients' individual circumstance will depend on the days used and the days rented.
I always can deduct my mortgage interest on my second home. With so many affluent clients purchasing McMansions these days, it is not uncommon to see a large mortgage on their primary residence. Remind your clients that you can generally deduct qualified residence interest on up to $1.1 million of home mortgage debt ($1 million worth of acquisition debt on up to two homes plus $100,000 of home equity debt on up to two homes). Any excess interest on home mortgage debt is generally nondeductible. Furthermore, the owner's overall interest deduction may be lessened due to the itemized deduction phase-out rule for higher-income taxpayers (for 2007 the AGI level is $156,400). This rule is expected to sunset by 2010. As such, if nothing is done, in 2011 it will revert back to a full phaseout.
I always have to report rental income. Rental income is completely tax-free for property that meets the rules for personal-use property, but has a very limited opportunity to generate rental income (generally 14 days or less). From a tax perspective, this can be quite a boon for clients with properties that can be rented at an exorbitant rate for a short time (e.g., properties located near a major golf event, Olympics, or Super Bowl location).
Vacation home donations are always a good idea. Unfortunately, the IRS considers vacation home donation days as personal use days, not rental days, since the owner did not receive a fair market rental for the use of the home. In addition to not qualifying for additional rental expenses, the owner receives no charitable deduction for donating the use of the home to charity.
I can use the capital-gains tax exclusion ($500,000) upon sale. The exclusion applies only to principal residences. Typically, to be eligible for the full exclusion, a taxpayer must have owned the home--and lived in it as his or her principal residence--for at least two of the five years prior to the sale. The property can change status but a homeowner can take advantage of the capital-gains tax exclusion only once every two years.
A 1031 (tax-deferred) exchange can be done on a vacation home. A recent Tax Court ruling (Moore, T.C. Memo 2007-134) disallowed tax-deferred treatment for a personal vacation home. The court held that a couple's exchange of vacation homes did not qualify for like-kind exchange treatment because the homes were not held for investment purposes (as required by ? 1031(a)). The court pointed to the taxpayers' use of the houses as vacation homes, their failure to rent either the old or the new property, and the personal improvements they made as evidence that the homes were for personal use, rather than for investment.
Rental income will be offset by costs. With property prices still high, some clients may believe they will offset the cost of a second home by renting it. Unfortunately, clients forget that in order to cover their costs they often will have to rent it out at peak season, coincidently the weeks they want to use it the most. Furthermore, when the house is used as both rental and personal property, on the owner's tax return, allowable operating expenses are limited up to the point where rental income is zeroed out. Any disallowed operating expenses are carried over to future years where they can be deducted if there are rental profits. In real life, this rarely occurs.
This is a "business." Many people say they manage their property and thus "materially participate." In other words, they are in the business of renting real estate and are able to take losses against other taxable income (i.e., it is not passive). (See Web extras for the IRS take on what it means to materially participate).
You can go home again. And, finally, do not "impulse buy" while enjoying a vacation.
If your clients have shown an interest in purchasing real estate at a great place where they vacationed last month, suggest that they hold off until they have "felt out the neighborhood" for a while, meaning they should visit the location a few more times. Suggest that they focus on the commute to work, the community, people, activities, and amenities, and, very important, talk to as many locals as possible, particularly those who have owned vacation homes there for some time.
Do your clients have a similar feeling of happiness each time they visit the location? Are their experiences consistent over time? If not, you have just saved your clients from a disastrous impulse buy. If it is what they dreamed of, then you now have an opportunity to help them with their financing and perhaps other assets as well.
The financial ramifications as well as the emotional toll of purchasing vacation homes can be complicated. But understanding these rules and your clients' expectations will open the door to some great discussions with your clients as well as other advisors they may have.
Susan L. Hirshman, CFP, CPA, CFA, CLU, is a managing director for JPMorgan Asset Management in New York. In that position, she develops strategies to provide wealth solutions to the affluent market. She can be reached at firstname.lastname@example.org.