Buying a vacation home that you intend to rent out for part or all of the year is a unique investment strategy because it offers a degree of personal enjoyment as well as the potential for financial gain. If making a profit is a primary goal, however, you'll need to make sure your purchase makes sound financial sense. You'll need to assess whether projected rental income will cover the full cost of owning the vacation property, or whether the anticipated appreciation of the property will adequately offset any operating losses you might suffer. Making such an assessment will require an understanding of the relevant tax laws as well as the real estate market as a whole and, in particular, the area where your vacation home is located.
Caution: There are inherent risks associated with real estate investments and the real estate industry, each of which could have an adverse effect on the financial performance and value of a real estate investment. Some of these risks include a deterioration in national, regional, and local economies; tenant defaults; local real estate conditions, such as an oversupply of, or a reduction in demand for, rental space; property mismanagement; changes in operating costs and expenses, including increasing insurance costs, energy prices, real estate taxes, and the costs of compliance with laws, regulations, and government policies. Real estate investments may not be appropriate for all investors.
Vacation Home Tax Considerations
Your tax situation depends on how often you use the vacation property personally and how often you rent it out. Personal use of the property includes any use of the property by family members or individuals who do not pay a fair rental price.
Renting The Property for Fewer Than 15 Days
If you rent out a vacation property for fewer than 15 days in a given year, the property is considered a second home, regardless of the amount of personal use. Any rental income you collect in this case is tax free, and no rental expenses (e.g., repairs, utilities) can be deducted. However, as with your primary residence, mortgage interest and property taxes can be deducted as itemized deductions (subject to specific limits).
Minimal Personal Use of The Property
If you rent out your vacation property for 15 days or more, the tax treatment depends upon your personal use of the property. If you limit your personal use of the property to the greater of 14 days or 10 percent of the time the property is rented, you will not be considered to have used the vacation property as a home. Instead, the property is considered investment property.
Tip: Under the 14 day/10 percent rule, if you rent out the home for 90 days, you can use the property yourself for up to 14 days without affecting the tax treatment. If, you rent the home for 200 days a year, you can use it for up to 20 days (the greater of 14 days or 10 percent of the time the property was rented).
You must report all rental income you collect. You can deduct expenses that are directly attributable to rental use (e.g., advertising). Other expenses, like mortgage interest and depreciation, must be divided between rental use and personal use. For example, if you rented the property for 90 days and use it yourself for 10 days, you can take only 90 percent of mortgage interest and depreciation as a rental deduction. Prorated rental expenses that are deductible include mortgage interest, property taxes, insurance, repairs, utilities, and other operating expenses. Expenses allocable to personal use are generally not deductible, other than real estate taxes and any casualty losses, which can be claimed as itemized deductions.
Caution: You cannot claim the portion of mortgage interest that is allocated to personal use as an itemized deduction because your personal use of the property is minimal, and the property will not qualify as a personal residence for purposes of the mortgage interest deduction rules.
Tip: IRS Publication 527, Residential Rental Property explains that expenses should be allocated without considering days the property was unoccupied. However, court cases have allowed the allocation method to factor in days the property stood unoccupied. Talk to a tax professional for details. If rental expenses exceed rental income, the amount of loss that you can deduct may be limited. In general, losses from rental real estate can only be deducted against income from other passive activities. You may be able to deduct up to $25,000 from other income, however, as long as you "actively participated" in managing the property. This allowance begins to phase out for taxpayers with adjusted gross incomes over $100,000 and is eliminated entirely for incomes in excess of $150,000.
Caution: You may be treated as "actively participating" if you make management decisions in a significant and bona fide sense. Although it is permissible to hire a professional property manager, you must make at least the major decisions such as setting rental rates, approving new tenants, and authorizing major expenditures.
Caution: Points paid to a lender on a vacation home are not immediately deductible as they generally are for your principal residence; they must be deducted over the life of the loan.
Caution: If you rent to relatives at discount rates, the IRS may rule that the house is not actual rental property and disallow some of your deductions.
More Substantial Personal Use of The Vacation Property
If you rent out vacation property for at least 15 days in a given year and your personal usage exceeds the greater of 14 days or 10 percent of the time the property is rented, the property is considered both rental property and a second home. You must report all rental income you receive. Just as the case with minimal personal use property, you can deduct expenses that are directly attributable to rental use (e.g., advertising), while other expenses, like mortgage interest and depreciation, must be allocated between rental use and personal use.
Even though most expenses allocable to personal use are still generally not deductible, mortgage interest that is allocated to personal use can be claimed as an itemized deduction in addition to real estate taxes and any casualty losses. Rental expenses are deductible only to the extent of rental income and they must be allocated in the following order (1) expenses directly attributable to rental use, (2) interest and taxes, (3) operating costs, and (4) depreciation. If expenses exceed rental income, the loss may not be used to offset other income. However, the excess can be carried forward to the next year and treated as rental expenses for the same property.
If you are allowed to deduct rental expenses, you may also be able to deduct depreciation. You can deduct the portion of the purchase price that went for the building (the cost of land is not depreciable) over a period of years (currently 27½ years using the straight-line method). If you subsequently make improvements to the property, you can also depreciate them. Because different rules apply to the original purchase and each improvement, calculating the correct amount of your deduction may be complicated, and you should keep complete and accurate records to back up your computations. Also, be aware that depreciating assets reduces your basis for figuring gain or loss on a later sale. Even if you did not claim depreciation that you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted.
Repairs Versus Improvements
Because they are treated differently for tax purposes, you need to be able to classify the work you do to the house as either a repair or an improvement. Repairs keep your property in good working order but do not materially add to the value of the property or substantially prolong its life. Repairs are considered expenses and may be deducted as rental expenses in the year they are incurred. Improvements, by comparison, add to the value of the property, prolong its useful life, or adapt it to new uses. Improvements are classified as capital expenditures and are added to your basis in the property, which can be recovered through depreciation.
Sale of Vacation Property
You should be aware of the tax considerations involved in selling a vacation home. Such a sale (regardless of whether it is classified as rental property, a second home, or both) does not receive the same tax benefits as the sale of a principal residence. If you sell your principal residence at a gain and meet the requirements, you can exclude up to $250,000 (up to $500,000 for married couples filing jointly) of the capital gain. A vacation home will not be eligible for this exclusion.
Tip: Your vacation home may qualify for the exclusion if you sell your principal home and live in your vacation home for at least two years before selling it. However, because of provisions in the Housing and Economic Recovery Act of 2008, even if you qualify for the exclusion, you may owe taxes on a portion of your capital gains from the sale. The amount excluded from tax will depend on the amount of time the property was used as a vacation or rental property after 2008 compared to the total time you have owned the property. For example, if you owned a home for 16 years before moving into it as your principal residence in 2010 and then selling it in 2012, the two years in which it was a second home AFTER 2008 (2009-2010) would represent roughly 11.1 percent of the total 18 years you owned the property (2 divided by 18=11.1 percent). That means 11.1 percent of your gain upon selling would be taxable; the rest would qualify for the exclusion. If your vacation home is classified as a second home, second home tax rules will apply. If your vacation home is classified as rental property or part rental property/part second home, any gain must be calculated as if you had owned two properties--one for personal use and one for rental use. Gain attributable to the personal use portion is reportable as capital gain. The gain attributable to the rental portion of the vacation home may be considered part ordinary income and part capital gain.
Exchange of Rental Property
Section 1031 of the Internal Revenue Code provides that federal capital gains taxes can be deferred when investment real estate is exchanged rather than sold. The regulations involving what are known as like-kind exchanges represent an extremely complex area of tax law and you should consult an experienced tax professional, but here are some basic rules:
- The property must be classified as rental/investment property (i.e., your personal usage must not exceed the 14 day/10 percent rule)
- The properties exchanged must be of "like-kind" (i.e., real estate must be exchanged for real estate, but they need not be the same grade, quality, type, or class)
- There must be an exchange of the like-kind property, rather than a sale and then a separate purchase
- The exchange will be tax-deferred (gain or loss) so long as the replacement property is identified within 45 days and actually received within 180 days from the transfer of the old property
An exchange may require the receipt of money or other property in order to equalize the value of the properties being exchanged. Such additional assets are typically referred to as "boot" and may be taxable if gain is recognized, but not in excess of the fair market value of the boot. Generally, the basis of the property received is the same as the basis of the property transferred.
Caution: Vacation home tax considerations are complex. For more information, you can refer to IRS Publication 527, Residential Rental Property, and consult your tax advisor.
Tip: Be sure to keep careful tax records relating to your vacation home just in case the IRS audits your tax returns. Without good records, especially regarding personal use time, you could lose your vacation home tax advantages.
What Are The Risks?
General Real Estate Risks
Risks inherent in any real estate investment include:
- Lack of liquidity: Selling real estate takes more time than other types of investments. If you must sell the property quickly, you risk having to settle for a price that is below fair market value.
- Market risk: Factors such as an overall economic decline, adverse changes in tax laws, or a decrease in demand can influence real estate values. The value of your home is not guaranteed to go up, and it could go down.
- Financial risk: Fluctuations in interest rates can also affect the value of real estate.
- Real estate expenses: Costs associated with the purchase, sale, maintenance, and management of real estate can affect profitability.
Risks Specific to Vacation Home Rentals
Besides the risks that are inherent in any real estate investment, renting your vacation home has special risks, including:
- Certain economic factors: High unemployment, high gas prices, or other factors can directly affect the vacation rental industry by discouraging vacationers from taking trips.
- Natural phenomena: Bad weather, lack of snowfall, fire, beach erosion, and other natural disasters can affect the demand for seasonal rentals. • Wear and tear: There will be some wear and tear, just as there is wear and tear in your own home. Unless your vacation home is maintained, it will produce less and less income, so it is vital to keep the property in top condition at all times.
- Property damage or loss by tenants: Unruly tenants may damage your property or steal your belongings.
- Overbuilding: If the area becomes a popular tourist destination, the vacation home you love now for its beautiful view could look out onto other vacation homes in a few years.
Tip: Having adequate and appropriate insurance can help offset some of these risks.
Vacation Home Mortgages May Be More Difficult To Obtain
You may find that lenders are less willing to make a second-home loan than a principal-home loan. This is because the finances of a second-home buyer are likely to be stretched thinner. Because of the increased risk of default, vacation home loans tend to require more money down, carry higher interest rates, charge more points, and impose other restrictions.
Renting Vacation Property Requires Effort
Before you purchase vacation rental property, you need to decide how you will provide for its management and maintenance. You may do this yourself or you can hire professionals to do it for you. Either option has its drawbacks. If you manage the property yourself, make sure your schedule can accommodate the time commitment. Some of the necessary tasks include:
- Placing ads, listing the rental, and/or creating a website
- Talking to prospective renters
- Checking references and credit reports
- Sending and receiving correspondences
- Setting and collecting rents
- Cleaning up between renters
If you maintain the property yourself, you will need a certain degree of handyman skills. If you hire professionals, you give up a certain degree of control, their salaries will cut into your profits, and you may lose certain tax advantages.
Income And Capital Gains From Rental Property May Be Subject to Investment Tax
Net rental income (income minus expenses) and net capital gains from the sale of rental property will be included when calculating whether your total investment income is subject to the 3.8% tax that applies to individuals with an adjusted gross income (AGI) above $200,000 and couples filing a joint return with more than $250,000 AGI.
How Do You Choose Vacation Property?
Find A Place You Will Enjoy
If you're investing in a rental vacation home, you'll want to find property that will provide pleasure as well as value. Most vacation homeowners prefer locations that fit their personal and recreational interests; skiers tend to flock to the slopes, golfers to golf resorts, nature lovers to the mountains or desert, water sports fans to the ocean, lakes, or rivers. So first, define your interests. Next, consider travel distance and cost.
Choose a location that's not too far or too expensive for you. If you plan to spend weekends at your vacation home, travel the distance on a Friday afternoon to see whether the drive will be manageable. Finally, before you decide to buy, rent in the area several times (during different seasons, if possible). This way, you'll get to know first hand about the lifestyle of the area. This will also give you an opportunity to tour properties for sale and consult other nearby property owners about local attractions, the crime rate, and future community plans.
Choose The Style of Property
You should also consider which styles of property will suit your needs best. If upkeep and security are concerns, a condo may be preferable. On the other hand, if you desire privacy, or if you plan on retiring to your vacation home, a single-family dwelling may be more suitable.
Determine If The Purchase Makes Financial Sense
You may find the perfect vacation for personal reasons, but as an investor, you must decide if it's a good investment. The first thing you should do is to determine whether the vacation property you are considering buying is priced fairly. Check real estate ads and ask local real estate brokers for prices of comparable vacation properties in the area. Next, you should consider the anticipated growth in the value of the property. This can be a difficult task since you're trying to predict the future. However, here are a few things to think about:
- Is there growth potential in the area, or is the area already built up or even overbuilt?
- Is the area coming into favor with vacationers?
- Are you planning to improve the property significantly?
Finally, analyze projected cash flow. Will expected rental income meet your expenses? Here are some things you will need to consider:
- What is the supply and demand for rental properties in the area?
- What is the rent that is being charged for comparable properties in the area?
- How many days will you be able to rent out the house during the year?
- How much will your annual expenses be?
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