Vacation Home

June 2024

Time spent at a favorite vacation spot inevitably leads to thoughts of buying a second home. Fortunately, the tax implications of a second home facilitate turning the dream into reality. Favorable income tax rules incentivize the purchase because a deduction is allowed for interest paid on a principal residence, as well as one additional home.

With proper probate avoidance planning, other expenses associated with a second home are also reduced.

Interest deduction

Although I.R.C. § 163(h) generally provides that personal interest is nondeductible, the section also provides a favorable exception for qualified residence interest that applies to both a principal residence plus one other residence. A taxpayer is thus permitted to deduct interest for two homes.

There is allowed as a deduction all interest paid or accrued within the taxable year on indebtedness that is qualified residence interest. I.R.C. §§ 163(a) & (h)(2)(D).

“Qualified residence interest” means any interest which is paid or accrued during the taxable year on acquisition indebtedness with respect to any qualified residence of the taxpayer. I.R.C. § 163(h)(3).

“Qualified residence” means the principal residence of the taxpayer and one other residence selected and used as a residence within the meaning of I.R.C. § 280A(d)(1) (i.e., generally more than 14 days per year). I.R.C. § 163(h)(4)(A).

“Acquisition indebtedness” means any indebtedness incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and secured by the residence. I.R.C. § 163(h)(3)(B).

This favorable rule, however, is subject to a dollar limitation. The aggregate amount treated as acquisition indebtedness for any period shall not exceed $750,000 (previously $1 million before December 16, 2017). I.R.C. §§ 163(h)(3)(B)(ii) & (h)(3)(F). A reasonable method of allocation is used to apply the limitation, such as chronological.

EXAMPLE: A and B are married. In 2021, they purchase a principal residence in Texas for $800,000. The consideration includes cash of $160,000 and a promissory note of $640,000 secured by the residence. The Texas residence constitutes a qualified residence of A and B, and the loan constitutes acquisition indebtedness. I.R.C. §§ 163(h)(3)(B) & (h)(4)(A)(i)(I).

In 2024, A and B purchase a vacation home in Florida for $600,000. The consideration includes cash of $120,000 and a promissory note of $480,000 secured by the residence. They use the Florida residence for personal purposes for the entire month of June, and do not rent the property. I.R.C. § 280A(d)(1). The Florida residence constitutes a qualified residence of A and B, and the loan constitutes acquisition indebtedness, but only to the extent of $110,000 (750,000 - 640,000 = 110,000). I.R.C. §§ 163(h)(3)(B)(ii), (h)(3)(F) & (h)(4)(A)(i)(II).

A and B are allowed a deduction for interest paid on $750,000 of loans - $640,000 for the Texas property, and $110,000 for the Florida property. I.R.C. §§ 163(a) & (h)(2)(D). Interest on $370,000 (480,000 - 110,000 = 370,000) of the loan for the Florida property is nondeductible personal interest. I.R.C. § 163(h)(1).

Reporting of qualified residence interest is made on Form 1098 and deducted on Form 1040, Schedule A. Please see Publication 936.

If the second home is rented, then additional tax considerations exist. Please see Publication 527.

Probate avoidance

To avoid the cost and delay associated with ancillary probate in another state, a homeowner should consider holding title to a second home in a revocable trust (rather than in the homeowner’s name, or as joint tenants with rights of survivorship).

A revocable trust is a will substitute that transfers a future interest to the remainder beneficiary of the trust. Restatement Third, Property (Wills and Other Donative Transfers) § 7.1, cmt. b.

EXAMPLE: A is the parent of C and lives in Texas. In 2024, A purchases a vacation home in Florida. Title is taken in the name of a revocable trust with A as trustee and remainder to C (rather than in the name of A, or in the name of A and C as joint tenants with rights of survivorship). In 2025, A dies survived by C. The trust is nontestamentary. C’s future interest becomes possessory at A’s death. The trust corpus passes to C outside of probate.

The interest deduction under I.R.C. § 163(h) discussed above remains applicable. Any residence held by a trust is treated as a qualified residence of the trust if the residence is a qualified residence of a beneficiary who has a present interest in the trust. I.R.C. § 163(h)(4)(D).

Matthew S. Beard, P.C.

3838 Oak Lawn, Suite 1220

Dallas, TX 75219

(214) 434-1813