Should You Purchase A Vacation Home?

Summer has arrived, and for many families, that means getting away for a few weeks. While enjoying beautiful surroundings, warm sun or cultural enrichment, it’s easy to imagine how nice it would be to own a home that would let you do so whenever you wanted.

But don’t let your imagination run away with you. Before you snap up a beach house or a mountain cabin, give the same thought to the purchase as you would to buying your primary home.

The first question is whether you can afford a vacation home. Have you covered educational expenses for your children? Is your retirement secure? Is your emergency fund solid? Don’t rob yourself of essentials to cover a second home, no matter how great its potential as an asset. Even if you buy the property outright, you may not be able to access the equity for some time.

A second home entails more expense than you might imagine. Beyond the purchase price, you will need to consider maintenance, security or a caretaker, utilities, property taxes, furnishings, travel costs and other items. You may also need to pay association or assessment fees. And if you intend to rent your property, you will most likely need to pay for advertising, and possibly for a property manager.

Further, insurance can be a major expense. Property insurance for a second home often costs more than for a primary residence, and may be more difficult to obtain. The more the house will be vacant, the higher you can generally expect premiums to be. Insurers may also want you to pay more if you plan to rent the property. In areas where floods or hurricanes are possible, flood insurance generally must be added separately.

When considering how you will finance the home, remember that second mortgages are usually more expensive than primary mortgages, as banks tend to believe that they are assuming more risk. Lenders may look at an applicant’s income, rather than general assets, which can make approval harder for retirees or those approaching retirement. Some buyers consider taking home equity loans on their primary residences to fund second homes, but this puts your primary home at risk.

When deciding whether a vacation home is a practical purchase, estimate all these expenses to get an idea of the carrying costs for the property. If you plan to maintain the property mainly for your personal use, divide the costs by the number of days you plan to visit, so you can see whether renting a home or staying in a hotel might be sounder financially.

Some people do consider a vacation home a moneymaking vehicle, or choose to use it for both personal pleasure and to generate income. However, counting on rental income to net a profit after expenses may not always be realistic. In a high-demand locale, such as a ski resort or a desirable beach, your chances are slightly better, especially if your property is within a three-hour drive or so of a major metropolitan center. But the fact remains that, while 25 percent of vacation homeowners say they intend to rent their second homes, only 15 percent do so. Those who do so profitably form an even smaller group.

Perhaps the most important financial consideration is the tax implications of a second home. The primary factor affecting your personal tax situation for a vacation home is the property’s anticipated use. Will your second home be used only by you, your friends and your family? Is it practical to rent it to others seeking a vacation site? Specific tax rules for renting out your vacation home may help guide this decision.

You must first determine whether your vacation home is considered a residence or a rental property. The Internal Revenue Service considers your second home a residence if you personally use it for either 14 days a year or more than 10 percent of the number of days the home is rented out, whichever is more. Your use, a relative’s use or use by an unrelated party renting at less than 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 expenses may be limited. Renting a property that the IRS considers a residence does not qualify as a “passive activity” for the purpose of income taxes. This matters because a loss incurred from one passive activity can be used to offset the income gained by another. Since renting a second residence is not a passive activity, you cannot use any rental expenses in excess of your rental income to offset income from other sources.

If the IRS considers your vacation home a residence and you rent the home out at least 15 days in a given year, you must characterize the division between rental use and private use. You must report all rental income in your gross income in addition to accurately dividing your expenses between personal use and rental use. Certain expenses, such as mortgage interest and property taxes, are usually fully deductible no matter how they are characterized, but are reported in different ways – to offset rental income if they are rental expenses or as itemized deductions if they are personal.

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