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.
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.