Second Homes and Tax Nightmares

I’ve recently been enamored with the thought of picking up a piece of lakefront property. For whatever reason, I’m very attracted to the the idea of owning a nearby bit of shoreline with a view toward building a getaway that could eventually serve as our retirement home.

Of course, this is a long-term vision, and we’re definitely still in the musing stage. We won’t be acting rashly (if at all), especially given the current uncertainty in the real estate market. That being said, I’m always interested in stories about people who own multiple properties. Over the weekend I ran across another such story while reading Don’t Mess With Taxes.

A taxing situation

The story that I’m referring to actually focused on real estate investors/speculators who’ve been struggling to stay afloat in the current market, so it’s not directly germane to our situation. Nonetheless, it’s still an interesting (and somewhat instructive) story.

The article leads in with the following ominous statement:

“Some of the biggest losers in the real estate slump are not purchasers of mansions they could not afford. They are buyers of second homes — or third ones, for that matter — who are sitting on a tax time bomb.”

The problem is that, although Congress has granted some tax relief to people who lose their primary homes, these measures don’t extend to those who default on a secondary residence or investment property. More specifically, under the Mortgage Forgiveness Debt Relief Act, a homeowner does not have to pay tax on debt forgiven by a lender as long as the loan is backed by the property the homeowner lives in. But…

For those that are upside down on a secondary residence going into foreclosure, the difference between what they owe and the eventual sale price of the foreclosed property will be treated as a taxable gift of forgiven debt. In other words, if you owe $250k on a house and it sells for $200k following foreclosure, you’ll have to pay taxes on the $50k difference. Ouch. Well deserved, but still… Ouch.

In many cases, the problem started to brew when a homeowner borrowed against the equity in the over-inflated primary residence to buy a vacation property. Often times, this was followed by borrowing against the equity in the secondary residence as it increased in value such that they could buy yet more property. Anyone with half a brain should’ve been able to see where this was headed, and yet many didn’t.

Additional downsides

As a side note, it’s worth noting that there are other unattractive tax consequences associated with secondary properties. They’re not nearly as disastrous as the situation that I outlined above, but they’re still worth knowing about. For example, you can’t claim a homestead exemption on a secondary residence. Also, unlike the case with your primary residence, you’ll face capital gains taxes on the full amount of the profits resulting from the sale of a secondary residence (unless you’ve lived in it for two of the previous five years).

So where does that leave us? Undeterred. But still undecided.

11 Responses to “Second Homes and Tax Nightmares”

  1. Anonymous

    My husband and I own 5 rental properteries and one of them we had sold on a LC. The LC expired in 2005 however the LC owner still lived in the property until July of 2008, they continued to pay monthly payments and was all paid current and also paid taxes current. In July 2008, the property had a fire and destroyed the home and the LC owner moved out, leaving the home behind. The LC owner was suppose to carry insurance on the property however was not paid current on home owners insurance, therfore it is now a loss, unfortunately we did not have any insurance on the property either. Can you provide some details on us claiming this property as a losss on our taxes. If we can claim it, can we still take the $ we might get back at tax time from the loss of the property and fix up the property and begin to rent it out again? Are there any tax provisions to doing so, or do we have to demolish the property? Thanks for any input on this situation.

  2. Anonymous

    I own a house free and clear in california,I bought a 2nd home in alaska that i stay in for a month every year.I decided to sell the house in alaska,what is the story on capitol gain on the second house.?Please advise.

  3. Anonymous

    A CPA just gave a talk at the local real estate investor group that stated if you have land and no income from that land you can’t write off expenses (if there’s no income). He stated the IRS is going to be heavily auditing for this issue.

    Since I’ve always had rental property I agree (2008) that it shouldn’t be highly leveraged. We’re always required to put 20% down (which isn’t enough), pay 6% property taxes and put up with tenants breaking leases and doing things that normal folks can’t imagine.

    The only people doing well in rentals are second generation heirs who still manage their family property. You must have gobs of money to be a real estate investor. Dave Ramsey says most of the investors he sees lack cash. He recommends only 15 year mortgages and he would be right.

  4. Anonymous

    I would be careful about the advice in Comment #1 above. This kind of advice can get you in trouble with the IRS very quickly.

    As a real estate investor myself, I would also caution you about renting out the property. Nobody here has mentioned that yet, but this is something that is routinely done with 2nd homes. One must take great care to avoid overstaying in the 2nd home when renting so that it can actually be counted as an investment and not a pleasure home. There are some great books, especially from on these very sorts of tax issues for rental properties.

  5. Anonymous

    A second home represents a LOT of work, to say nothing of the added expense. My friends who own a second home in the nearby high country keep trying to persuade me to buy up there.

    My house is paid for, and I don’t want another mortgage. Also, the amount they’re paying in taxes on a two-bedroom miner’s shack is as much as I pay on my four-bedroom centrally located house on a third of an acre! But expense aside, I’ve watched them and the other folks who own in that little town, and though they love visiting the place because of the peace and quiet, fact is that once they arrive they have yard work, repair work, cleaning, and painting to do. They have to hire a local handyman or neighbor to maintain the place in their absence, and they STILL have to spend a fair amount of their “leisure” time doing house- and yardwork. Ugh. Surely there’s a better way to have fun?

    With plenty of work and expense involved in maintaining my present home, it strikes me you’d be better off to rent a place in a second-home or resort area. Someone else can take care of it, while you bank the amount that ownership would have cost. Then you get to drive up there at your convenience, not because something needs to be fixed, painted, cleaned, trimmed, watered, or mowed.

    If you figured the average monthly cost of owning a place and invested that amount, when you were ready to retire you’d probably have enough, combined with your home equity, to buy your dream home in your dream venue, free & clear.

  6. Anonymous

    One interesting phenomenon I’ve seen involved people getting HELOCs on their rental properties and never really paying them down. On the one hand, better than the primary residence if they’re paying off the primary residence. But floating the credit instead of putting the rent to work against the mortgage sounds scary to me.

    I don’t feel like being that involved in my investments anyway, doesn’t work with my personality.

  7. Anonymous

    I have a second home on the WA coast, 3 hours from my primary residence. We built it with cash so there is no mortgage, but it still costs us about $400 every month to own in taxes and utilities. We are out there about 1 weekend per month most of the year and 3 full weeks at Christmas and over the summer. We have the beach house because we love it. I hope to retire there. In the mean time, it is quite expensive to own a second home and a lot of the time we’re out there, we do maintenance. My advise to you- if you love it- then go for it. Just do thorough research first. We see a lot of short-term neighbors and second homes in distress because people don’t realize what they are committing to. Good luck!

  8. Anonymous

    Even for people who got themselves three-deep leveraging their equity, they *still* wouldn’t be in a pinch if they hadn’t also chosen variable-rate mortgages. Leveraging to the max isn’t for me, even if I remain in control of my own destiny. But leveraging to the max and then placing it all at the mercy of the nation’s interest rates is insanity.

  9. Anonymous

    I don’t post often, but I check your site often. Our daughter attends Ole Miss. Oxford is growing and we enjoy visiting as it is just over 1 hour away. We decided to buy a condo within walking distance of the campus (1/2 mile). With 2 roommates it costs the same as renting an apartment, assuming we can get our money out in a couple of years. Prices are up so we feel good about that.

    Here comes our warning. We did everything as friends because her roommates were friends. When asked if they were staying the next year, we were assured they were. No need to look for more roommates. Oops! Come May, they go home and announce they are not paying rent for the summer but are leaving their belongings. I am ready to kick them out, but they are close friends. After a lot of back and forth, they pay for part of a month, we found 1 roommate for part of the summer, we are out 2 months rent times 2, and we have learned an expensive lesson.

    Guess who now has signed leases in their possession for next year. Wish us luck in a few years when we sell.

    ps. Our son is headed to Mississippi State. He will live in rented housing.

  10. Anonymous

    We have a second home that we use as a vacation place. Personally I think the trick is to minimize your risk by putting a significant cash down payment on the property. In our case, we put a significant amount down and then built the place with sweat equity and paid cash along the way. We owe very little on the property and are able to write off the interest each year because we used a little bit of equity from our main house. At this point, we now have a fully owned house on paper. If we needed to, or decided to, we could sell our main house, take a large chunk of equity away after the sale and live in our vacation house tax free. I’ve found that gives me some peace of mind. Our main house is the only debt that we have and to know that we could sell it (even in a very “down” market) and live completely debt free is somewhat exciting.

    All that being said, there are a lot of monthly costs involved when you have a second place. We have to pay monthly HOA dues (to support a water system and lake front park) and also have to pay property taxes, insurance, electric, cable, etc etc bills.

    No question that it’s a decision that shouldn’t be made lightly. If you are buying a second home as a rental, it’s obviously a much better long term financial decision. I pay a fair amount of money every month to have a place sit empty 75% of the time. (But we sure do enjoy the 25% of the time)

    Here is a link to our lake house:

  11. Anonymous

    I would add, as a real estate investor, that second, third or fourth properties can lower one’s current tax burden (assuming that you are collecting rent but still taking a loss [i.e. – you do improvements each year]). If the property you are looking to invest in is only land (i.e. lakefront property) you won’t have rental income to offset the loss so its also a tax write off. And when you go to the lake each year for vacation you can write off the cost of the trip b/c you are visiting your investment.

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