Is It a Vacation Home Or a Rental Property Investment?
A vacation home is usually a property where you plan to spend a significant amount of time away from your primary residence. Many people use their second home for recreational purposes, as a way to fold into their lives something that they otherwise can't get--a peaceful rural setting, a nearby golf course, a mountain slope for skiing and summer recreation, a lakefront view, or an oceanside retreat. Some people buy a vacation home for the future, as a place to which they plan to retire. Some rent it out when it is not in use, helping to subsidize the cost of owning and maintaining it. But by definition, a vacation home is not a rental property-it is used primarily by the owner.
If you own vacation property and rent it out for less than fourteen days, you are allowed to treat the property as if it were a primary residence for tax purposes. Since a vacation home generates a negative cash flow for most owners (the expenses of ownership almost always exceed any rental income it brings in), you will be able to deduct property and mortgage interest.You are allowed to deduct the interest associated with the first $1 million of debt used to purchase, build, or improve your principal residence and one vacation home. These deductions, however, are reduced for high-income taxpayers, as with any deduction. At a certain income level, the IRS no longer permits you 100 percent of itemized deductions; it begins a small phase-out of these deductions-including mortgage interest. (Please see your accountant for more information.) If you do not rent out your vacation home for more than fourteen days per year, you pay no tax on rental income. However, you cannot deduct rental expenses. If you rent your vacation home for more than fourteen days per year, you have to treat your second home as rental property for tax purposes. The rental income less expenses and depreciation must be included in your taxable income. However, you may deduct property taxes and mortgage interest and all other rental expenses associated with the property, including depreciation. To the extent that rental expenses are not deductible in the year they are incurred, they can be carried forward to future years.
More and more households look to rent their vacation property to help defray costs. With vacation property values rising, this rental strategy makes sense. Nonetheless, for most vacation properties, particularly in the "hot" vacation locations, rental income will likely not cover your property expenses (including mortgage payments). One alternative is to look for a vacation property in a less desirable, less expensive market (e.g., Myrtle Beach, South Carolina). You may not have to rent your property as many weeks per year in a less expensive area for you to be able to financially carry the property.
Vacation Property Types
For purposes of expanding your real estate reach, vacation real estate falls into only two categories: single-family homes and condominiums.
Single-Family Detached Homes
A single-family vacation home is far and away the most popular kind of second home. A single-family property gives you far more privacy than a condominium, although it will cost more in maintenance and repair. Moreover, it has the potential to become your primary residence in the future, or your retirement home.
Condominiums
In recent years, condominiums have gained favor as a second home. First, they are relatively cheap compared with single-family houses, allowing more people to buy second homes. And the process of purchasing a unit in a condominium complex is less complicated and expensive. Some condominium associations have rental programs, helping you rent your condo when you are not using it. (However, there may be restrictions on the rental terms. For example, some developments only permit an investor to rent on an annual basis, not month-to-month.) Condos are a great way of getting into a vacation property without overstretching your financial resources. But condos do come with other responsibilities and expenses.
Condo fees (association fees) can be a significant part of your monthly expenses even if you are not using the property. If you are renting the property regularly, the association adds property management fees on top. You need to know what you will have to pay for things like finding renters, providing maid service, and extra maintenance costs. If you plan to rent your condominium, be conservative with your rental income projections. Request a copy of the financial statements showing the unit's rental income over the past three years.
Time-Shares
Time-shares became popular in the 1980s because most households could not afford a full-time vacation home. American developers got the idea of shared ownership from European developers, who successfully used the time-share concept in the 1960s. Shared ownership reduces the costs for each owner, allowing developers to successfully market and sell properties to a greater number of people. Time-shares are defined as buying the right to occupy a unit (one or more rooms with varying amenities) for a limited period of time (usually one, two, or three weeks) during a certain time each year at a certain location. I don't regard time-shares as genuine real estate investments. Buying a time-share gives you the right to use the property for a specific period of time each year, but you have no real equity in it. You don't actually own the physical property in which the unit you use is located; you own a certain amount of time during which you can occupy a unit. Time-shares are an investment in vacation activities, rather than an investment in real estate. As a result, I will not spend any more time on time-shares in this book.
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