Should You Buy A Vacation Home? Summer has arrived, and for many families, it means being away for a few weeks. While enjoying the beautiful surroundings, warm sunshine or cultural enrichment, it’s easy to imagine how nice it would be to have a home that allows you to do so whenever you want.
But don’t let your imagination run with you. Before you buy a beach house or mountain cabin, think about the same purchases you made for your main home.
The first question is whether you can afford a vacation home. Have you covered your child’s education costs? Is your retirement safe? Is your emergency fund solid? Don’t rob yourself of the essentials to cover a second home, no matter how great its potential as an asset. Even if you buy property outright, you may not be able to access equity for some time.
Second homes cost more than you might think. Beyond the purchase price, you need to consider maintenance, security or guards, utilities, property taxes, furniture, travel expenses, and other items. You may also need to pay an association or appraisal fee. And if you intend to rent your property, you will most likely have to pay for advertising, and possibly for the property manager.
Furthermore, insurance can be a major expense. Property insurance for a second home is often more expensive than a primary residence, and may be more difficult to obtain. The more vacant homes, the higher the premium you usually expect. The insurer may also want you to pay more if you plan to rent the property. In areas where flooding or hurricanes are likely, flood insurance should generally be added separately.
When considering how you will finance your home, keep in mind that second mortgages are usually more expensive than primary mortgages, because banks tend to believe they are taking on more of the risk. Lenders may look at the applicant’s income, not general assets, which can make approval more difficult for retirees or those approaching retirement.
Some buyers consider taking out a home equity loan in their primary residence to fund a second home, but this puts your primary home at risk.
When deciding whether a vacation home is a practical purchase, estimate all of these expenses to get an idea of the cost of holding the property. If you plan to maintain the property primarily for your personal use, divide the cost by the number of days you plan to visit, so you can see if renting a house or staying in a hotel might be financially better.
Some people think of vacation homes as money-making vehicles, or choose to use them both for personal enjoyment and to generate income. However, relying on rental income for net income after expenses may not always be realistic. In high-demand locations, such as ski resorts or desirable beaches, your chances are slightly better, especially if your property is within a three-hour drive or more of a major metropolitan center.
But the fact remains that, while 25 percent of vacation home owners say they intend to rent their second home, only 15 percent do. Those who do so profitably form even smaller groups.
Perhaps the most important financial consideration is the tax implications of a second home. The main factor affecting your personal tax situation for a vacation home is the anticipated use of the property. Will your second home be used only by you, your friends and family? Is it practical to rent it out to someone else looking for a vacation spot? Specific tax rules for renting out your vacation home can help guide this decision.
You must first determine whether your vacation home is considered a residence or rental property. The Internal Revenue Service considers your second home to be a residence if you personally use it for 14 days a year or more than 10 percent of the number of days the home is rented, whichever is longer.
Your use, use of relatives or use by an unrelated party renting for less than the fair price, all count as “personal use” in determining the nature of the property.
If your vacation home is considered a residence, certain deductible rental costs may be limited. Renting a property that the IRS considers a residence does not qualify as a “passive activity” for income tax purposes. This is important because the losses incurred from one but are reported in different ways – to offset rental income if they are rental expenses or as itemized deductions if they are personal.
Other expenses, including maintenance fees, insurance, depreciation and other costs involved with renting out your vacation home are only used to offset rental income when they can be classified as rental expenses. (A complete list of deductible expenses can be found in IRS Publication 527, “Residential Rental Property.”) The allocation to rental use determines the amount of your expenses used to offset rental income.
If you rent the home for half of the year, then half of your expenses may be deducted against your rental income. Given the complications of this division, it is probably wise to involve a tax professional if you intend to use your property for both personal and substantial rental activity.
If you do not want the burdens of allocating expenses and continually seeking renters, consider taking advantage of the preferential tax treatment the IRS offers for short-term rentals. The IRS permits you to rent your vacation home for fewer than 15 days annually without reporting any rental income in your total income, thus tax-free.
Understandably, you may not deduct any expenses related to renting the home, as there is no reported rental income to offset. In this scenario, you would itemize all of your mortgage interest and property tax deductions on Schedule A.
If your second home will be primarily for personal use, be aware of residency rules in the states where both of your homes are located if they are not the same. Reestablishing your residency can be useful, but is sometimes challenging. New York, for example, is notorious for finding ways to keep its former residents on the tax rolls.
A former New Yorker may want to take advantage of Florida’s preferable tax climate, but it isn’t simply a matter of deciding it’s a good idea.
While a timeshare may seem like a better idea on paper than buying a vacation home, the reality makes it unappealing for most people. In a timeshare, you pay a lump sum up front and maintenance fees thereafter. Atraditional timeshare then guarantees you the use of a specific unit at the same time every year (typically for a week, though it varies).
Some newer timeshares operate on a points system, which gives users more flexibility in when and where they vacation, but also leads to competition for the best units at the most desirable times.
Though a timeshare is cheaper at the outset than buying a vacation home, it does not offer the same equity or appreciation potential. In effect, you are simply paying for years of vacations in advance, not investing. Additionally, maintenance fees can increase, and most timeshares don’t have a built-in expiration date.
Because timeshare property is notoriously hard to sell, this can leave you (and potentially your heirs) indefinitely paying fees on a property you no longer wish to use. You would likely do better to earmark a portion of your portfolio for an annual vacation rather than to purchase a timeshare. This would allow your assets to appreciate, and would avoid the risk of locking yourself into an agreement with no simple exit.
If you decide to purchase a vacation home, several considerations remain. Location is crucial. Choose a region where you will want to be often – once a year or more – and possibly to the exclusion of other travel, depending on your time and resources. Rural areas can sometimes increase expenses; for example, insurance may be more costly if you are far from the nearest fire station.
In addition, many desirable vacation properties are at increased risk for floods or earthquakes, further driving potential insurance costs up. If your desired property is abroad, review that country’s ownership laws and its history of honoring ownership claims from noncitizens.
Finally, think ahead to the possibility of selling your vacation home one day. As soon as your use of the property declines, it is probably better to sell it to eliminate the carrying costs and free the capital for other purposes. You may use the house less than you expected, or you may have used it a great deal when your children were younger but less now that they have become adults.
Regardless, getting the process under way as soon as you know you want to sell is important. The housing market is still relatively weak, so it may take longer to sell the property than you expect.
If you rent your vacation home enough for it to be characterized as a rental property, you will want to recover the cost of the home through depreciation. Recovery of the cost for residential rental property under the General Depreciation System (GDS) spans 27.5 years.
This capitalized expense can be used to offset rental income, thus lowering your tax bill. Deducting depreciation may cause a net loss on your rental property; however, since your second home qualifies as rental property and not as a residence, you can reduce other income froem passive activities with losses. Remember, if you are visiting your home on vacation, you should only deduct the depreciation allocated to the rental days.
When the time comes to sell your vacation home, be aware that the IRS will treat the sale differently than your primary home. Your vacation home does not benefit from the $250,000 capital gain ($500,000 if joint marriage application) exemption made by your primary residence. If you have owned the property for at least 12 months, any gain from the sale will be taxed at the long-term capital gains rate.
In addition, if you claim depreciation on your home due to rental use, you will need to reset your cost base to determine profit. Even if you don’t claim the depreciation deduction, you will still have to deduct the basic cost of the home by the amount of depreciation you can take. The portion of the gain on sales due to depreciation that lowers your base is considered depreciation recoverable and will be taxed at 25 percent.
A lose-lose scenario arises when selling a vacation home; You do not receive any of the capital gains exemptions mentioned above, nor do you receive any tax benefits if you incur a loss on the sale. For this reason, consider converting your vacation home into your primary residence before selling it.
If you make your second home your primary residence for two of the five years prior to the sale, you will be eligible for the maximum capital gains exemption.
If you want to keep the vacation home in the family instead of selling it, it can lead to some estate planning complications. No matter how well your children get along, owning shared property can lead to disagreements and hurt feelings, as can giving one child a home and another child of less sentimental value.
Even if your children share without issue, they may pass it on to their children, resulting in the division of property between eight or 12 cousins who may or may not know or like each other very much. Those who want to keep the property may not be able to buy those who want to sell it. Overall, it can create drama that you might not expect.
In cases where selling the house is too painful or impractical for the rest of your life, you can direct your estate to sell it and divide the proceeds among your heirs. Alternatively, you can set up a trust for the operating expenses of the property, then have your heirs use it in certain circumstances.
Whatever you do, state your wishes, both in your will and by discussing them with your children or heirs. Ideally, involve a financial planner or estate planning attorney. Put everything in writing.
A vacation home can be a wonderful luxury, providing a place to get away from your everyday life and to build precious memories with friends and family. As long as you consider it a purchase and not an investment, you can make the right decision about what is right for you. Then, if you buy a vacation home, you can approach it with realistic expectations and a good chance of enjoying it for years to come.