Vacation Homes - To buy or not to buy

If you are anything like me, you begin to truly relax around the third day of your vacation. Soon after that, you visualize what life would be like working from a beach house six months out of the year.  Then you start to analyze:  How can I be sure I can afford the purchase? Is it a good investment?  Are there tax consequences?    

Here are some thoughts to get you started:

1. Know your plan

Be realistic in your expectations of rental income.  Roughly 25 percent of vacation homes are rented to other people for at least part of the year and much of that rental activity is seasonal.  Use a conservative estimate as to how often you will really visit. If you don't rent out your unit, you want to make sure you will visit enough to make the purchase worthwhile. Pick a place you love and want to return to often as you won't want your home to sit unoccupied.

Calculate your return on investment. If owning a vacation home is part of your overall investment strategy, make sure it's a good move. Estimate returns and weigh them against other uses of the same money.

2. Know your costs

To purchase a vacation home, you should be able to comfortably put down at least 20 percent of the purchase price.  In the current market, if you are qualified, you should be able to find a second-home mortgage comparable to first-home rates.  However, the lender will want to ensure that your overall income can support both mortgages.

You will also have to pay utilities, HOA or condo fees, property taxes, insurance, utilities, house cleaning, trash removal, landscaping and home furnishings.  Particularly if you live a distance away from this home, remember to install a security monitoring system.

3. Know the rules

Not all homes can be used as rental property. Homeowner or condo associations may set rules for rentals, as may cities. Some resorts may require you to use their programs, which set standards for interior furnishings and amenities, but the property handles the logistics for a percentage of the rent. If you plan to rent out your property, it's especially important to research all these rules before you buy.

If you plan to visit infrequently, give strong consideration to hiring a local property manager that will maintain your home. It will cost extra, but so will the damage from those frozen pipes or leaky roof, especially if it goes unnoticed for a long period of time.

4. Know the tax consequences

Rental income is taxable on federal and most state returns, though with careful planning, your expenses should offset this income.  If your deductible rental expenses are more than your gross rental income, you will report a loss.  This loss, unfortunately, is not generally deductible unless you qualify as a real estate professional.  If you are not a real estate professional, there can be other benefits to the loss.

Vacation homes are subject to what's called the 14-day or 10 percent rule. You can rent your home for up to 14 days a year and pocket the rental income without having to declare it on your tax return. If you rent out the house for more than 14 days a year, you are considered a landlord by the IRS and you must report the income but will also qualify to deduct certain rental-related expenses.

5. Know the end game

Purchasing any form of real estate is among the most illiquid investments.  It is a major commitment, your principal is difficult to access and there is no guarantee of profit.  If you do manage to sell for a profit, you will almost certainly be subject to capital gains tax. The actual amount of that tax will vary depending upon your adjusted gross income as well as your home state tax rules.   There are other more complicated rules pertaining to depreciation recapture which will you need to pay.  If you sell the home for a loss, it may or may not be deductible depending upon the rental activity.

Here is one way to potentially postpone those gains:  you can convert your vacation home to your primary home.  The catch is that you must have owned and lived in the home as your primary residence for two of the five years prior to sale.  There are other specific requirements as well so, if you choose this route, definitely reach out to your accountant.

With any major purchase, you must be confident that it something you can comfortably afford.  Consider a vacation home more of a luxury than an investment; this will help to manage your expectations.  If you become serious about moving forward, put together a spreadsheet of all the costs and be completely sure you can afford this commitment.  And, as always, find yourself a good attorney and CPA who can provide you with critical guidance.