Most owners of second homes leave a lot of money on the table, especially when it’s time to sell the house or pass it on to the next generation of owners.
There are three basic choices for transferring ownership of the second home, but the details of each option are flexible. Most vacation homes and second homes appreciate in value, so I’m going to assume the property has appreciated substantially.
Of course, the first option is simply to sell the property. A sale is especially attractive when there is a significant gain to cash in and it appears unlikely the next generation of the family will use the house much.
But a sale would incur capital gains taxes, and the amount of the gain probably is enough to push you into a higher tax bracket. The tax bill depends on your state of residence and tax bracket. The federal tax can be as high as 23.8%, and being in a high tax state could increase the bill to 35% of the gain or more.
Before selling, estimate the taxes and other selling costs to see how much you’d net.
The tax burden might be reduced or avoided if you have capital losses that can offset the gain, either loss carryovers from prior years or new losses from selling investments this year.
When you don’t need the cash from a sale, compare the results of a sale to continuing to own the property.
The taxes can be avoided by holding the property the rest of your life and passing it to your children through the estate. The children then get to increase the tax basis to its fair market value and sell it immediately for no taxable gain. The appreciation during your lifetime would avoid income taxes. Most people under current law would avoid estate taxes or incur lower estate taxes than capital gains taxes. (Keep in mind that there are proposals in Congress to eliminate the step-up in basis at death. If enacted, this change would require your estate or your heirs to pay capital gains taxes on the appreciation that occurred during your lifetime.)
MORE FOR YOU
A long shot strategy is to convert the house into your principal residence for a few years. Then, you can sell it and capture up to $250,000 of gains tax free if you are single and $500,000 if you are married filing jointly. But it takes some planning and work to convert a second home into a principal residence that qualifies for the tax-free gains.
You also can consider converting the house to a rental property. Then, after some time passes you can exchange the property for another investment property of equal or greater value.
A third general option is to give the property to your children (or grandchildren or others of your choice).
Giving the property to your children generally makes sense mostly if your estate is likely to be taxable. A gift removes both the property’s current value and its future appreciation from your estate. You probably will use some of your lifetime gift tax exemption to avoid taxes on the gift, and that would reduce your estate’s exemption amount.
When your estate won’t be taxable, it makes more tax sense to hold the property for life and let your children inherit the property so they can increase the tax basis to its current fair market value. When you make a gift of the property, the children will take your tax basis and when they eventually sell they’ll pay capital gains on the appreciation that occurred during your lifetime.
In many cases the taxes on a gift would be less than the capital gains taxes on a sale. Work with your accountant or estate planner to estimate which would be more expensive. Keep in mind, as mentioned earlier, that the law could change in the next year or two so that capital gains taxes are imposed whether your children receive the house by a lifetime gift or through your estate. If that happens, you’ll have to re-evaluate your plan.
When a gift is the appropriate strategy, there are ways to reduce the amount of the taxable gift, especially when you give the property to more than one person.
Suppose you have three children. You can give each a one-third interest in the property. A minority ownership interest in a property usually is valued for gift taxes at less than the pro rata value of the entire property. That’s because minority owners have less control and influence over management of the property. Minority discounts usually are 20% or more. An alternative when you have only one child is to give the child 25% one year and additional minority interests in future years.
It often is better to put the house in a partnership or limited liability company first. Then, you can give interests in the partnership or LLC. That’s often easier than redoing the deed to reflect minority interests.
Carefully consider your options for a second home or vacation home. The decision could add a significant amount to your family’s after-tax wealth.