Millennials seem to be happy to rent rather than commit to home ownership, and overall home ownership is at a 19-year low. But home ownership still has advantages for family stability, building equity, responsible use of leverage through mortgage financing, and tax deductions. And a second home offers many of the same advantages.
If the property is used as a second home rather than rented out as a business property, mortgage interest is tax deductible to the same limits as a mortgage on a primary home. (Total mortgage debt up to $1.1 million is 100% tax deductible.) Property taxes on a second home are also fully tax deductible.
Renting the property for part of the year can become a bit complicated depending on the amount of personal and rental use. If the property is rented for 14 or fewer days during the year, the income is not reported at all and is completely tax-free, regardless of the amount. If the property is rented for more than 14 days, the income must be reported and the expenses can also be deducted. But the expenses must be allocated based on the time it is rented and the time it used for personal purposes and the allocation is based on the actual days of use. Not only would a portion of typical expenses be deductible but also the amount paid to a property or rental manager and partial depreciation of the property.
If renting the property results in a loss, things get even more complicated. If there are more than 14 days of personal use, or more than 10% of the number of days it is rented (whichever is more) the loss can’t be deducted. One way to keep down the days of personal use is to keep records of time spent maintaining the property because those days are not considered personal use. If the loss can be taken, it falls under the “passive loss” rules and deductibility depends on overall income. Losses that can’t be deducted because of higher other income can be retained and used to offset profit when the property is sold.
Generally, any profit from selling a second home is taxed as a capital gain. However, if an owner makes the second home his personal residence for two of the five years prior to sale, a portion of the gain can qualify for the exclusion of gains from selling a home. The portion of gain that is subject to taxes is based on the ratio of the years since 2008 the home was a second home to the total number of years the home was owned.
All the tax considerations aside, there are other reasons to consider a second home. A second home allows the chance to become familiar with and involved in another community without career pressures or limitations. Storing vacation items in a second home can greatly simplify travel and packing and can maximize leisure time. Vacation homes can become the center of regular gatherings and can be passed down to the next generations, preserving family history and relationships even as the family may disperse. Finally, buying a second home in a potential retirement area before retirement provides the chance to “test the waters” and adjust retirement plans if the reality turns out to be different than expected.
Those advantages are offset by the need to maintain another home; who wants to spend an entire vacation working on a home? Travel time and expense are big considerations and have a direct impact on how often the home can be used. The time and financial commitments to a second home create an obligation to use it to the exclusion of other vacation destinations. A second home is also “illiquid” and can take a long time to sell.
As the saying goes, all real estate is local, and that maxim is even more applicable to vacation homes. Along with the overall real estate decline, second home prices fell 30% to 50% depending on location. Vacation home areas can be heavily dependent on attractions like a nearby ski area or entertainment destination, mountain homes may be vulnerable to forest fires and beach houses are susceptible to beach erosion as well as hurricanes. Supply and demand are magnified in vacation home markets, many of which are small in size and can be greatly affected by the fortunes of nearby population centers.
In 2013, vacation home sales were up almost 30% from the year before to 717,000 but are still 1/3 below the peak in 2006, according to the National Association of Realtors (NAR). The median vacation-home price was $168,700, up 12.5% from $150,000 in 2012, with 36% purchased for cash and an average down payment of 30% for buyers using a mortgage. The NAR also reports:
The typical vacation-home buyer was 43 years old, had a median household income of $85,600 and purchased a property that was a median distance of 180 miles from his or her primary residence; 46% of vacation homes were within 100 miles and 34% were more than 500 miles. Buyers plan to own their recreational property for a median of 6 years, down from 10 years in 2012. (Might this suggest that speculation is creeping back into the vacation home market?)
Buyers listed many reasons for purchasing a vacation home: 87% want to use the property for vacations or as a family retreat, 31% plan to use it as a primary residence in the future, 28% wanted to diversify their investments or saw a good investment opportunity, 23% plan to rent to others and 22% intend it for use by a family member, friend or relative.
All things considered, owning a second home can be a positive experience and should depend on whether it fits within the owner’s means and the extent to which it can be used and enjoyed. To stretch financially to buy a second home or to purchase primarily on the expectation of appreciation in value fall into the speculation category. If the goal is just an enjoyable vacation, it would probably be better to rent.