What to look for when buying a second home

Regardless of your reasons for purchasing a second residence, there are important questions to ask yourself so you end up with the best home for your situation.

"Consider the practical and emotional value of the property—as well as its cost and location—before you take the plunge," says Michele Lindzy, a mortgage advisory leader for First Citizens Wealth. "It's easy to fall in love with a great property at a good price, but make sure you consider other factors too before jumping in."

Homebuying questions to answer

There are several factors to consider before adding a new property to your real estate portfolio.

What's the best location for me and my family, both now and later?

Think about why you're buying a second home. Is climate a big factor? How about proximity to activities and interests you enjoy, like searching for antiques, playing golf or skiing? Do you want something more remote and rustic, or is being close to good shopping, entertainment and restaurants more important to you?

If one of your goals is to invest in a place where friends and family gather, consider its distance and ease of access for those visiting you. If you plan to retire to your second home, think about its proximity to healthcare services, and recognize the importance of building a network of friends and supportive relationships once you get there.

How will I finance a second home?

Depending on your financial situation, you can work with a dedicated private mortgage lender or opt to buy or build your second home with cash. Instead of dipping into your investments and taking a tax hit when choosing the latter, consider borrowing against your investments with a line of credit.

That's what Max and Susan Lee did when they decided to build a second home near the ski resort their family had visited for years. When they sold their business a few months earlier, the couple put the proceeds into a diversified portfolio of investments that could potentially keep their money growing throughout their retirement. But when they needed money to build their vacation home, they were reluctant to tap into this nest egg and sell assets that would incur capital gains. Instead, they decided to pull cash out of a flexible line of credit.

This strategy allowed them to keep their diversified assets at work while they paid the contractor. And the cost of their variable-rate line of credit was more favorable than any construction loan they could find. Once the home was finished, they took out a conventional 15-year mortgage to pay off the credit line at a low fixed rate.

Will this affect other financial plans and priorities?

As recent wildfires, floods and hurricanes remind us, it's crucial to make sure your property is adequately protected and insured against both natural and manmade disasters. Factor in the high cost of flood and storm insurance if you're buying near the ocean or on a river, as well as the cost and availability of fire insurance if you're in a remote location that relies on a volunteer fire crew.

There also may be covenants on shoreline property that restrict how and what you can build to prevent future storm damage and beach erosion. And if you plan on renting out your property, you'll want to check on whether your casualty insurance and personal liability limits should be higher.

If you're thinking about purchasing a vacation rental property purely for its investment potential, do so with some caution. Real estate can be a good diversification strategy because its performance isn't correlated to stocks. But you also don't want to overdo your allocation to real estate by purchasing an individual property that'll be a large, illiquid asset in your investment mix.

How will it affect my tax situation?

Check in with your accountant and tax advisor before buying a second home to understand the tax implications of your purchase.

You may find that the real estate taxes for your vacation property are much higher than those for your primary residence because the town or state has lower tax revenues. Or you may want to look for a location for your eventual retirement where you won't have to pay any state or local income taxes if you become a resident, like New Hampshire, Florida or Nevada.

In addition, the Tax Cuts and Jobs Act limits how much you can deduct for mortgage interest and property taxes paid on your second home. This makes it important to understand and plan for the act's estate and gift tax sunset scheduled for 2026.

Under the tax law:

• The maximum deduction you can take each year on your federal tax return for state and local taxes—also known as the SALT deduction—is $10,000.
• Joint tax filers can only deduct mortgage interest on up to $750,000 of the mortgage debt incurred to buy or improve a first or second property residence, and the limit for married couples filing separate returns is $375,000.
• You may be able to avoid paying some taxes in the state of your primary residence when you spend time at your vacation home by deducting the percentage of days you're there each year from your primary residence's state tax obligation.

Should I consider becoming a permanent resident in the new location?

If you're thinking about changing your primary residence from your current home to your vacation property as you get closer to retirement, knowing the rules for residency is key because they vary from state to state.

Most states use both quantitative and qualitative elements to determine a residency for tax purposes, but the details are different for each state. Typically, to be considered a full-time resident in a new state, you must sever tax ties with the jurisdiction you're leaving and build new ties—both formal and informal—in the state where you intend to establish residency.

What are the estate and legacy planning implications?

Purchasing a new vacation property may also mean making changes to your estate planning documents to reflect how you want this new asset to be managed at your death or incapacity.

Answer the following questions so your updated estate plan aligns with your wishes.

• Will you title the asset in your own name, either jointly or individually, or in the name of a trust?
• If the property is in another state, should you put it in a trust to avoid probate in two separate states?
• If you rent out your vacation home, should you hold the property in a limited liability company, or LLC, to reduce personal liability?
• Will you gift your vacation home outright to beneficiaries, or will you create partial interests to be divided among them and then held in a trust?

If your vacation home becomes your permanent residence, you'll also need to revise your estate planning documents to reflect this change. This is particularly important if the new state has different marital property rules or special forms for medical directives, healthcare proxies and powers of attorney.

If you've already funded a living trust in your former state, this could trigger income-tax consequences in that state—regardless of whether you're still a resident there. To avoid this tax implication, terminate the previously funded trust and transfer the assets into a new trust established in your new state.

If you're purchasing a residence in a continuing care retirement community, ask your advisor to look over the terms to understand how it could affect your cash flow and estate plan.

The bottom line

Because buying a second home is such a big decision that involves so many aspects, planning is essential. This way, you can give yourself the best opportunity to make the right choice for your lifestyle and budget.