Should I Buy a Vacation Home or Rental Property?

In this article, we will discuss key considerations for buying a second home or other rental property. Many of our clients are considering purchases in places they visit frequently. In this article, we discuss the key considerations in this important decision, including:

• Real estate investment returns

• Key tax breaks for second homes

• Mortgage financing

• Types of real estate and REITs

• Rental income

• LLCs and risk management

• Unexpected challenges

• Buying vs. renting

Can I afford it?

The first, and most important, consideration is whether a purchase will compromise your other financial goals and values. We will discuss financial benefits, like tax breaks and rental income, but those can all change with legislation and market conditions. If you can’t afford the mortgage without rental income, you may be in for a challenge during rental market downturns. Bottom line, make sure you buy something that you can afford prior to help from tax benefits and rental income.

Are vacation homes and rental properties a good investment?

Real estate as an asset class has performed well over long periods of time. Like all assets, diversification is important. Real estate should be part of any modern investment portfolio, but not make up an entire portfolio. Back in January, we discussed real estate and real assets in more detail in our article on building modern portfolios. Over the long-term, real estate has performed well, providing returns well in excess of inflation and bonds. As a result, many institutional and professional investors own real estate in their portfolios. We believe real estate is an appropriate asset for many of our clients as well.

When thinking about individual property purchases, location and property selection are key. Not all assets appreciate to the same extent, as evidenced in the chart below. The chart shows a housing price index for various cities over the last 10 years. You can see sometimes significant differences based on location. Additionally, within cities or resort areas, different submarkets will produce different results. Knowing the local market and working with local real estate professionals is key. Also, the last decade has produced strong results due to low interest rates. While we expect real estate to continue to appreciate, the past decade is not necessarily a good indicator of the next decade. Lastly, rental homes and vacation properties tend to have implicit leverage. You invest 20%-40% in a down-payment and finance the remainder of the purchase. Leverage always magnifies positive and negative returns. This can mean significant positive or negative results when compared to the remainder of your portfolio.

Source: FactSet, S&P Case-Shiller

What types of real estate can I own?

Many investors skip right to single-property residential real estate, specifically single-family homes, when they think about investing. The universe is much more broad than single-family and different real estate assets are useful in different types of portfolios. In your own experience, you probably lived in student housing and an apartment (multi-family residential) before you purchased your first home. There is also real estate that is used for commercial purposes, storage, data centers and many others. Each type of property has unique characteristics and may be beneficial for different types of investors, so explore the universe before making a decision.

In addition to simply buying one or two individual properties, REITS (Real Estate Investment Trusts) can be used to invest in a broad basket of real estate within your investment portfolio. REITS buy hundreds or thousands of properties, thus investors benefit from diversification across assets. REITs can be public or private. Funds may employ leverage (debt) or no leverage. Each fund is unique. For investors interested in real estate purely as an asset class in a portfolio, often REITS can achieve investment objectives without the risk and administration of single property ownership.

What are the tax breaks for second homes and rentals?

Will I get a tax break? The primary tax break for second homes is the deduction of expenses against your other income. Expenses include operating expenses like property management and maintenance as well as depreciation expense, which reduces the value of the property for tax purposes. Keep in mind, when you depreciate an asset, you will eventually pay more in capital gains taxes when you sell. So depreciation may or may not be beneficial long-term. Whether or not you may deduct operating expenses depends on whether the property is treated as a business, which can take losses, or a personal property, which is more limited. The IRS uses the number of days you rent the home each year compared to the number of days you use the home for yourself to make this determination.

• Rent less than 15 days:

  • No deductions for your taxes, but you also don’t pay taxes on rental income.

• Rent more than 14 days, use for yourself less than 14 days:

  • Property is considered a business and you will be able to deduct some or all of the expenses based on the percentage of days you used vs. rented the home.

• Rent more than 15 days, use for yourself more than 14 days:

  • Property is still considered a business and you will be able to deduct some or all of the expenses. However, you will not be able to take a loss on the property to offset other income. The expenses of the property can offset rental income and any excess loss is simply carried forward to future years.

The mortgage interest deduction is another potential tax reduction source for second homes. The IRS does allow interest deductions for your primary home plus one additional property. But, the total property value is now limited to $750,000. With increased home prices, many buyers find that their second home pushes them over the limit for interest deductibility.

So the bottom line on tax breaks, the more expensive the property, and the more you actually use a vacation home, the less friendly the tax treatment. Pure rental properties, which are a business 100% of the time, are more likely to result in favorable tax treatment than a vacation home that is used frequently. Consulting a tax advisor prior to a purchase is key to ensuring any benefits actually apply in your specific situation.

How should I finance a second home purchase?

Often clients use mortgage debt to finance the purchase of a second home. This is especially attractive when interest rates are low. Over long periods of time, property values tend to appreciate more than the cost of interest on a mortgage. Keep in mind, the bank will likely require more than 20% down to purchase a second home. Some areas may even require 40% or 50% down to get a deal done. Local lenders generally know the market better and will offer better terms than large national financial institutions. Also, banks will expect that you can cover the mortgage and other required expenses, like insurance, without rental income.

Should I buy a vacation home to produce rental income?

Research here is the key. The best case scenario for successful income investing is to purchase a property that is currently being used as a rental. The current owner can provide you with the rental rates and income. If you cannot find a property that is currently being rented, real estate agents or other local property investors can give you an idea of actual annual income. Just like all other markets, vacation rentals are subject to the ebbs and flows of supply and demand. You should not plan to rely on rental income to pay for property expenses on an annual basis. Rental income should be a nice addition, not your primary plan to pay for the home’s expenses. If you use mortgage debt, banks may want to see that the expenses can be covered without rental income as well. Remember rental management companies often charge 20+% of revenue for on-going management, so factor that into any rental income expectations. Also, the best rental rates occur during the times when everyone, including you, wants to use your property. Make sure that you take your personal use into account when you consider your projected rental income.

Do I need an LLC for real estate investing? What about other liability risks?

When you own a property, you generally become liable for issues that occur on your property. That includes injuries and other mishaps that may result in significant financial liability. As a result, property owners generally separate each individual rental property into a distinct legal entity, or limited liability company (LLC). This protects the owner’s personal assets and other properties from financial liabilities. We recommend reviewing the legal structure you intend to use prior to purchasing real estate assets. Different legal entity structures may also make financing more complicated. Banks want to ensure they are paid back in the event that the property stops producing income on its own. Rental property owners often carry additional insurance to cover unexpected liabilities that arise from the property. Solid legal and financial representation is key when considering a second home purchase.

Unexpected Challenges

Just like any business, unexpected challenges often occur with property rentals and vacation homes. Here are a few things to consider:

• Expenses will crop up, the air conditioning will go out in July. Owners spend an average of $13,000 annually on things like repairs according to HomeAdvisor.

• Leasing or renting may prove more difficult than you estimated. Many units were booked to capacity in 2018, then saw almost no use in 2019 and 2020 as Covid changed travel dynamics.

• Tenants may cancel or not pay, forcing costly evictions and causing lost revenue (assuming local laws even allow for eviction)

• New development may occur in an area, which can be positive or negative for your property

Thinking about how you will handle challenges ahead of time will help you manage them when they occur.

Should I rent or buy a vacation home?

The answer is really different for every person. But here are a few things to consider:

• Can you afford it without compromising your other goals?

• Do you really want to go to the same place more than 2-3 weeks a year? If not, you may be better off renting. Remember, you can invest in real estate through capital markets if your sole goal is investment related.

• Do you want to maintain the property? When you rent, you get to walk away and throw the keys to someone else to take care of maintenance issues.

• How will you finance the purchase?

• Have you consulted with the right legal, financial and tax experts to ensure you receive the expected benefit from your home purchase?

Once you can answer these key questions, you should have the information you need to make a smarter decision about purchasing properties.

Think you might benefit from professional expertise and guidance? Schedule an intro call to connect with our team. In these meetings, we simply ask a bunch of questions to get to know you and your situation. If we both think there is a fit, then we will schdule a subsequant meeting to discuss a specific proposal designed around your needs. Not ready for a call? Listen to The 6 Figure Investor Podcast anywhere you listen to podcasts.