When clients float the idea of buying a vacation home or becoming a landlord, the first thing their financial advisers bring up are taxes–both the benefits and pitfalls.
Advisers say a simple discussion with their clients can help them make the right decision on the best use for the property or whether they should buy the property at all.
For instance, a successful veterinarian recently learned this when he came to David L. Blain, a financial planner in New Bern, N.C., as a new client. Mr. Blain told the man he would likely keep losing money on a $200,000 single-family home he bought to rent out, thinking it would yield big tax write-offs.
Taxpayers are limited in how much they can deduct in losses on rental property they own. The most someone can deduct in losses is $25,000 a year in many circumstances. But for those with adjusted gross income over $100,000, the amount is phased out, dropping to zero at the $150,000 threshold. The veterinarian, who made over $1 million in 2012, didn’t know anything about this until Mr. Blain enlightened him. He would not have been able to deduct any losses until he sold the property.
“A lot of doctors fall for this,” Mr. Blain said. “They are told to get rental properties because they can take the losses.”
Several of his clients have bought second homes and investment properties recently. People feel more confident now that if they buy, for example, a beach house they have always wanted, it won’t lose its value anytime soon.
For advisers, a few probing questions at the outset can help uncover what kind of tax planning needs to be done. An adviser may ask a client whether their children are likely to want to inherit a piece of property. If so, a trust to pass the property to heirs to minimize gift and estate taxes may be in order.
Real estate in a recreational area, say, a ski cabin in Colorado, might be good as investment property. This carries a host of tax obligations, from reporting security deposits, expenses or advance rent paid by a tenant, to writing off depreciation, repairs and uncollected rents.
Chicago adviser Cicily Maton recommends clients–like the couple she works with who own a condominium in Panama that they rent out–use tax software to track expenses for their investment properties. “So people don’t have to spend the last part of March trying to gather everything,” said Ms. Maton, founder and partner in Aequus Wealth Management Resources.
When it comes to buying a second home, it’s key to know federal and state income tax rules. A lot of the same rules–including the mortgage-interest deduction–apply to both a primary residence and a second home.
But advance tax planning is key for anyone near retirement who’s thinking about buying a second home with an eye to moving in full-time at some point. Advisers see this a lot with so-called snowbirds who live in high-tax states most of the year but winter in Florida, which has no personal income tax.
The Internal Revenue Service and state tax authorities penalize those who report a home in one state as a primary residence when they are not residents there. Advisers can help lay the groundwork so that someone who moves isn’t questioned on this.
“They have to change where they are voting and document days,” said James J. Holtzman, a wealth manager at Legend Financial Advisors Inc. in Pittsburgh, with about $315 million under management. A new driver’s license is a key document needed to prove residency, he said.
In the past six months or so, clients have been more interested in real estate than in the last several years, according to Mr. Holtzman. Fortunately, he generally gets a word in before they pull the trigger.
“They usually ask me ‘Does it make sense? I’m thinking about doing it,’” he said.
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