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Vacation Home In The Mountains

Real Estate 101: Here's What You Need to Know Before You Buy a Vacation Home

Aug 22, 2019 by Matt Frankel, CFP
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Have you ever considered buying a property in your favorite vacation destination? Maybe you’re tired of paying high rental prices. Or your family needs more room than you can get in a hotel or reasonably priced vacation rental. Or maybe you just want a place for your family to gather whenever it’s convenient.

There are many good reasons, and places, to buy a vacation home. But, like any major financial decision, there’s a lot you should know before you commit.

For example, did you know that there’s a special category of mortgage loans for vacation homes and other non-primary residences? Or that property management fees for vacation rentals can be three times what you’d pay a property manager to manage a long-term rental property?

With that in mind, here’s a rundown of the pros and cons of buying a vacation home, as well as what you should know about taxes, financing, and other issues before you start looking for properties.

Reasons to buy a vacation home

Buying a vacation home is a major financial decision. Before you dive in, it’s important to understand the benefits and drawbacks.

We’ll start with the benefits. Here are some of the most common advantages of buying a vacation home:

  • You could save money in the long run if you vacation often. If you spend two months each summer at the beach, your annual mortgage payments on a vacation home could be comparable to what you pay to rent for two months. Plus you’ll be building up equity over time, not giving your money to someone else.
  • You may be able to use your vacation home to generate rental income when you aren’t there. In popular vacation destinations, this could turn the home into a serious money maker. We’ll get into details about this a bit later.
  • Real estate values -- especially in popular vacation areas -- tend to go up over time. Even if you don’t rent it out, your vacation home could help you build wealth.
  • You may be able to get tax breaks for mortgage interest and property taxes if you don’t primarily use your vacation home as a rental property.
  • You can customize a vacation home to fit your needs and preferences and you can store belongings there. For example, if you own a home at the beach, there’s no need to transport your beach chairs and your kids’ beach toys on every trip.
  • A vacation home could eventually be a full-time home. Buying a vacation home when you’re relatively young could give you a desirable place to retire down the road.

Of course, there are also intangible reasons to buy a vacation home, like giving your entire family a place to get away together. Everyone has their own reasons for wanting a vacation home.

Drawbacks to buying a vacation home

Vacation home ownership has drawbacks and it isn’t right for everybody. With that in mind, it’s important to consider these things before you buy:

  • Vacation homes are expensive, especially in popular destinations. My wife and I considered buying a two-bedroom condo at one of our favorite beach destinations. Then we saw that the median price of the homes was more than double what we paid for our primary home.
  • Besides paying the mortgage, you’ll also pay property taxes, insurance, utilities, and other expenses at two homes.
  • Vacation homes can be difficult to finance. Financing a vacation home can be difficult. Lenders charge higher interest rates and want higher down payments than they would for a comparable primary home.
  • Maintenance is your responsibility. You’ll have to handle maintenance issues yourself or pay someone else to do it.
  • Real estate isn't a liquid asset. It can be difficult to sell quickly without taking significantly less than the home is worth. Many financial planners don’t suggest buying a vacation home -- or any real estate -- unless you plan to own it for at least five years.

Now let's tackle some of the most common questions about vacation homes.

Do you get the same tax breaks with a vacation home as your main home?

You may be able to deduct your mortgage insurance and property taxes in the same manner as you would for a primary home. It depends on how much you rent out your vacation home.

Here's the key test. Do you live in the home

  • at least two weeks (14 days) out of the year or
  • 10% of the days it’s rented out?

If you do, you can treat it as a vacation home instead of an investment property. Keep in mind that you'll need to satisfy the condition that results in the higher number.

Let's say you own a condo in the mountains and rent it out for 180 days each year. You'd need to occupy the home at least 18 days out of the year to consider it a vacation home for tax purposes. If you spend 17 or fewer days there, it's an investment property.

The IRS lets taxpayers deduct the interest on as much as $750,000 of qualified personal residence debt. This includes the interest you pay on your primary home’s mortgage, a second or vacation home’s mortgage, and certain home equity debt from improving the property. Before the Tax Cuts and Jobs Act, the limit was $1 million in mortgage principal. Pre-existing mortgages were grandfathered in to the old limits.

You can deduct the property taxes you pay on your primary and vacation homes, but the state and local tax (SALT) deduction is now limited to $10,000 per year. This includes your real estate taxes and any state and local income taxes (or sales tax) that you pay. If you have more than one home, it’s common to have taxes that exceed the limit.

It's also important to know about a tax break that you don't get on a vacation home. When you sell a primary residence, you can exclude as much as $250,000 in capital gains ($500,000 for a married couple) from your taxes. If you paid $400,000 for your primary home and sell it for $500,000, you won’t pay any tax on the profit.

If this sale took place with a vacation home, you’d find yourself with $100,000 of taxable capital gains. A six-figure profit is certainly a good problem to have. But be aware of the tax implications.

Can you rent your vacation home out?

The short answer to this question is "yes." But doing so could have major tax implications.

houses for rent sign

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Remember the IRS threshold that distinguishes a sometimes-rented vacation home from an investment property? If you rent your property out, you need to occupy it for at least 14 days during the year or at least 10% of the number of days you rent it out. If you do, you can treat the vacation home as a secondary residence for tax purposes. If not, the IRS considers it an investment property. That's regardless of whether you primarily bought it for investment purposes.

Let’s start with the common implications. No matter how a rented property is classified, you must report rental income on your tax return. You can also deduct certain expenses from it. Imagine that you earned $5,000 of rental income last year and spent $2,000 on maintaining and repairing the property. In this case, you'd have $3,000 in taxable rental income.

Here’s the important part. If the IRS considers your vacation home an investment property, you can’t use the mortgage interest or property tax deductions. You can, however, deduct those from your taxable rental income and use the investment property depreciation deduction. That can have a big impact on your tax liability. In fact, many profitable investment properties show a loss for tax purposes because of the valuable tax benefits available to them.

We’ll get into financing vacation homes in a bit. Just remember that it can be much more difficult and expensive to finance an investment property than a home you intend to occupy (even if you rent it out).

If you only rent your vacation home out every once in a while...

The IRS has a special rule for properties that aren’t rented very often. If you rent your vacation home out for 14 days or less each year, you don’t have to report that rental income or pay any taxes on it. Even if you rent your home out and make thousands of dollars in those two weeks, the IRS can’t touch a penny.

Just something to keep in mind.

Are you allowed to rent your vacation home out?

Another question to answer before you make an offer is whether you’re even allowed to rent the home out.

Many vacation destinations have restrictions on rentals. For example, I used to live in Key West, Florida. Rentals for less than a month at a time are prohibited by the city unless you get a very expensive “transient license” for the property.

Some condominiums or homeowners associations (HOAs) also have restrictions on rentals. One condo I looked at prohibits rentals until you’ve owned the property for at least a year. This discourages people from buying units purely for investment purposes. Others don’t allow short-term rentals at all. And "short-term rental" has a variety of potential definitions.

If you’re planning to rent your vacation home out, or relying on being able to rent it so you can afford it, make sure that you’re allowed to. In many places, the fines for illegally renting a property are quite severe and enforcement efforts are widespread. Don’t think you can just rent it anyway. A local real estate agent should be able to help you figure out if a particular property is rentable and what restrictions exist.

How much does it cost to hire a property manager for a vacation home?

Another thing to think about before renting your vacation home is whether you want to self-manage or hire a property manager. It can be extremely difficult, if not impossible, to manage a vacation rental yourself if you don’t live nearby. There’s too much that needs to be coordinated in person. You'll need to make sure the property is cleaned between renters and be nearby to deal with lockouts and maintenance problems.

The problem with hiring a property manager is that it’s expensive. For long-term rental properties, the industry standard property management fee is 10% of the rental income collected. With vacation rentals, the standard fee jumps to 25–30% of the rent. That’s a lot of money. If your beach condo brings in $1,500 per week, you could pay your property manager more than $5,000 during a three-month busy season.

Why so expensive? Because managing a vacation rental is much more time-consuming than managing a long-term rental. Think about it this way. If you buy a duplex as a rental property, your property manager has to find a tenant, have them agree to a year-long lease, and deal with the occasional maintenance issue. With a vacation rental, the manager needs to market the property constantly, coordinate regular cleanings and maintenance, and deal with vacationers’ problems.

Hiring a property manager to oversee your vacation home rental is a big expense. But many owners find it well worth the cost. Plus, if your manager can market the property more effectively than you can, the resulting increase in occupancy and average rates can help offset the fee.

How do you finance a vacation home?

The most well-known types of mortgages are for primary homes and investment properties. However, there's a third option that sits between the two. They're typically called “second home” mortgages.

Someone Sitting In a Hammock Relaxing

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Second home mortgages are a bit tougher to qualify for than primary residence loans. Lenders often want larger down payments and you can expect a higher interest rate. Do you already have a mortgage on your primary home? Your income needs to be high enough to justify both mortgage payments.

However, a second home mortgage tends to be significantly easier to qualify for than an investment property loan. And it’s also typically less expensive -- in terms of interest rates and fees -- than an investment property loan.

You may be wondering why financing a vacation home is any different than financing a primary home. If you aren’t planning to rent the home, what’s the difference to a lender?

The short answer is that a vacation home represents a larger risk to the lender. After all, if you’re having trouble making the payments on your vacation home and the bank forecloses, you still have a primary home to live in. If your primary home is foreclosed upon, it’s a much worse situation to be in.

In other words, borrowers prioritize making payments on their primary homes in tough times. Lenders want larger down payments to ensure borrowers have lots of skin in the game.

Finally, it’s a good idea to get preapproved by a reputable lender. Stricter requirements and higher costs mean there are fewer truly qualified buyers in the market for second homes. Being able to show sellers that you’re preapproved as a second home buyer can make your offers carry more weight.

Do lenders definition second homes in the same way as the IRS?

Lenders may have different definitions than the IRS when it comes to issuing a second home mortgage. And that's important to keep in mind.

Many lenders won't originate a second home mortgage if you plan to rent the home out at all. To meet the definition of a second home for many lenders, the property must be available for use at all times and cannot be enrolled in any type of rental program. If you plan to rent out the home -- even occasionally -- some lenders will consider it an investment property.

But there's good news. Some lenders have more liberal definitions of what constitutes a second home. For example, one popular lender allows buyers to rent out their properties for as many as 180 days a year while still financing it as a second home.

One important piece of cautionary advice: Don’t tell a lender what they want to hear and rent the property out later. Getting a mortgage under false pretenses is a form of mortgage fraud. Lenders don’t check up on homebuyers often, but the penalties can be severe.

Is buying a vacation home the right move for you?

There’s a lot to consider before deciding whether a vacation home is a good idea for you. Be sure to weigh the pros and cons, consider the tax implications, and know what to expect when it comes time to apply for financing.

Purchasing a vacation home isn't a decision to be taken lightly. Make sure you know what you’re getting into before you start looking for a vacation home of your own.

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