5 Key Points: Buying a Second Home or Vacation Home

By: Scott Sturgeon, JD, MBA, CFP®

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Introduction

Of all the things to think about in buying a second home or vacation home, probably the most important is being very clear on why you’re doing it in the first place. Is it purely as an investment or personal use? Do you want it to generate cashflow for you? Are you open to actively managing it as a rental? If you make the purchase, are you going to feel obligated to only visit the place where you’re buying it? Whether it’s for purely personal use or as a rental, what does the financing, management, and other usage costs look like & how does that impact your personal cashflow? 

In this article, we’ll explore 5 key considerations for individuals interested in buying a vacation home or second home. From setting a realistic budget and understanding financing options to assessing tax implications and rental income potential, we will provide valuable insights to help you make a more informed decision for your vacation home or second home purchase and whether it’s truly a valid option for both your goals and financial situation.

1. Define Your Objectives for a Vacation Home 

Before diving into the financial aspects, it’s important to establish clear objectives for your vacation home or second home purchase. Are you seeking a serene vacation retreat or a long-term investment property? Do you want something that’s turn-key and ready to go? Or do you want to have your own HGTV mini-series buying a cheaper property & renovating? Understanding your goals and intent for the property will help shape your financial plan and guide your decision-making process effectively.

2. Setting a Realistic Budget for Your Second Home

Creating a realistic budget is a critical step in the financial planning process for a vacation home or second home. Consider both the upfront costs, such as down payment, closing costs, and potential renovation expenses, as well as ongoing expenses like mortgage payments, property taxes, insurance, maintenance, and utilities. Having a tool that can help you plan out those kinds of expenses can go a long way in making a final decision that puts you on a good financial footing. By carefully evaluating these costs, you can ensure that your budget aligns with your desired vacation home or second home purchase.

3. Financing Options for Your Vacation Home 

Explore different financing options available for purchasing a vacation home or second home. Whether it’s obtaining a traditional mortgage, leveraging home equity, or considering a cash purchase, understanding the pros and cons of each option is essential. Consulting with a mortgage professional or wealth advisor will help you determine a financing approach that’s a good fit based on your specific circumstances and financial objectives.

4. Tax Implications for Your Second Home

Comprehending the tax implications of owning a vacation home or second home is crucial. Depending on the property’s usage, you may be eligible for tax deductions or subject to specific tax obligations. How much tax benefit you can derive from a second home has a lot to do with whether you rent it out or use it to generate income. If it becomes an income producing entity, you’re able to then deduct many, if not all, of the expenses associated with creating that income.

For example, if your vacation home is out of state and you hire a management company to clean and maintain the property as tenants rent out the home, you can write off those maintenance costs against any income you generate. On top of deductions for expenses, you can also take depreciation on the property, which is basically a deduction taken over a series of years based on the value of the property, but may be subject to repayment if you eventually sell the second home. In the event you go to sell the property, you may also be subject to capital gains tax (or loss) depending on the value of the property relative to when you bought it.

Perhaps not surprisingly, it’s typically a good idea to seek guidance from a tax professional to understand how factors like rental income, property taxes, mortgage interest, depreciation, and cost basis will impact your overall tax liability.

5. Maximizing Rental Income Potential for Your Second Home

If you plan to rent out your vacation home or second home when it is not in use, it is essential to assess its rental income potential. Thoroughly research the rental market in the area, analyze rental rates, occupancy trends, and demand patterns. Additionally, consider the expenses associated with renting, such as property management fees, advertising costs, and maintenance. Evaluating the rental income potential will help you determine if your vacation home or second home can generate sufficient revenue to cover expenses and potentially yield a profit.

Remember, if you’re renting out your vacation home, you’re effectively now a landlord and should treat the property like a business. For some owners that can be a big negative to owning a second home, but for others who don’t mind the added time and costs involved, the resulting income and potential tax benefits can make it worthwhile. 

For those looking for a kind of “middle ground” on making their home a rental, remember that if you rent out the property for 14 days or less during the year, it’s basically tax free income as it doesn’t need to be reported on your tax return. The catch though is you’re also not able to deduct expenses like mortgage interest, management fees, or certain repair & maintenance costs. For those who are on the fence on whether to rent out a property, this can be a good “test run” of sorts to determine if becoming a landlord, property manager, or both, is what you’re truly looking for. 

5. Liability & Insurance Coverage for Your Vacation Home or Second Home

It’s important to remember that any time you acquire a piece of real estate, there is going to be some amount of liability that comes with it. Making sure you’re taking steps to reduce or protect yourself from that liability is critical to not only avoid keeping you up at night, but trying to avoid any kind of legal liability that could potentially arise from owning the property.

Ensure that you have adequate insurance coverage for your vacation home or second home. Discuss your needs with an insurance provider to understand the various policies available, such as homeowner’s insurance, landlord insurance, or vacation rental insurance. Familiarize yourself with coverage limits, deductibles, and any specific requirements related to insuring a vacation home or second home.

It may also be beneficial to transfer ownership of the vacation home into an LLC or similar entity to create a liability shield between your personal assets and the property. Note that in doing so, you should treat the second home almost like a business with a separate bank account, financing in the name of the entity, and treat it as something wholly separated from your other assets.

Lastly, purchasing an umbrella policy may be a worthwhile consideration to make. Umbrella policies are designed to protect you in the event of litigation or in the event you have some large insurance claim that exceeds your coverage amount from other policies. Used in conjunction with holding the property in an entity as previously described, it can be a powerful tool in reducing your overall liability.  

In Conclusion…

Purchasing a vacation home requires careful financial planning. By defining your objectives, setting a realistic budget, exploring financing options, understanding tax implications, maximizing rental income potential, and securing appropriate insurance coverage, you can navigate the financial aspects of owning a vacation home or second home successfully. Remember to consult with professionals, including wealth advisors, mortgage brokers, and tax professionals, to ensure you make well-informed decisions that align with your long-term goals.

Whether you’re seeking a peaceful getaway or a smart investment, the key is to approach the purchase of a second home with a solid financial foundation. By carefully considering these essential financial planning considerations, such as budgeting, financing, tax implications, rental income potential, and insurance coverage, you can confidently embark on your journey to owning a vacation home or second home. With thorough preparation and guidance, you can turn your dream of owning a second home into a reality while making sure it truly aligns your finances with what’s important in your life.

Curious to learn how working with a seasoned CFP® professional at Oread Wealth Partners can bring value to your unique financial situation? Let’s talk.

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