If it’s financially feasible for you, owning a second property can be an excellent investment. You can use the property as a vacation rental. Or you can retain it for your own vacation purposes and use it as a primary home during retirement.
However, before you jump on that cute bungalow you spotted on beverly-hanks.com, pause to assess the benefits and risks of such an investment. Owning any property carries a significant and ongoing financial burden—from mortgage and taxes to maintenance and repairs. For that reason, it’s in your best interest to make sure the investment is the right one for you.
There are many considerations to make before buying a second property, whether it’s a vacation home or vacation rental. This article does not cover them all. Instead, consider it a good primer to begin a conversation with your Allen Tate/Beverly-Hanks agent about which investments best fit your real estate goals.
First, What’s the Difference between a Vacation Home and a Vacation Rental?
Second homes. Vacation homes. Investment properties. To the average home buyer, these terms may feel interchangeable. But to the IRS and your mortgage lender, they mean very specific things:
Primary Residence – The main residence or dwelling in which you live—usually a house or apartment, but could include a houseboat or house trailer. Your primary residence is considered your legal residence for the purposes of declaring income tax or acquiring a mortgage. You can have only one primary residence at a given time, though you may share it with other people (namely, family members or roommates).
Second Home – A residence that you occupy for part of the year in addition to a primary residence. Typically, a second home is used as a vacation home, though it could be any property you visit regularly. For instance, if you live in the country but own a condo in the city where you work and spend part of the week, that would count as a second home. Second homes cannot be used to generate income through rentals.
Investment Property – A property that (1) is not your primary residence, and (2) is “purchased or used in order to generate income, profit from appreciation, or to take advantage of certain tax benefits”. This can include residential rental property, commercial property, and property purchased to “flip” for a profit. You are only allowed to use investment properties yourself, including vacation rentals, for a certain number of days per year.
For more information about investment properties, see our post: 3 Ways Second Homes Differ from Primary Homes and Investment Properties.
Pros and Cons of Buying a Second Home as Your Vacation Home
Second homes sound lovely in theory, but it’s important to review your short-term and long-term finances closely before purchasing one. According to Investopedia, “Keeping a second home is a step up in magnitude [from your first home] because a second home has all the costs (often more) of your first home without the easy write-offs from the IRS.”
Many lenders are more wary of making second-home loans than they are for primary homes. For this reason, they may require the property to be at least a certain distance from your primary residence or located in a resort or vacation area (e.g., near the ocean). They usually include a Second Home Rider along with the mortgage that states that you, the borrower, will not use the property as a rental, as a timeshare, or for other profit. So, you won’t be able to make any money off your second home. However, second-home loans do regularly have a lower interest rate than investment property loans, so there are some savings there.
Before you buy, consider the added costs associated with local taxes, HOA fees, and any property management or regular maintenance. Keep in mind that many lenders require that your second home be a minimum of 50 miles from your primary residence. This can make even small repairs challenging to take care of quickly unless you have systems and repair professionals in place.
As long as you follow your lender’s rules and use the property exclusively as your second home (and not a rental), there are some tax benefits. You can deduct mortgage interest similarly to how you would for your primary residence, up to a total of $750,000 in value between the two homes (if purchased after 2018). Property taxes may also be deductible, as well. Contact your Beverly-Hanks REALTORⓇ or real estate tax specialist for current information relevant to your investments.
Pros and Cons of Buying an Investment Property as a Vacation Rental
Because of lenders’ Second Home Riders and other restrictions from the IRS, it’s difficult to turn an existing second home into a profit-making investment property like a vacation rental. If you intend to develop an investment property, you should go into loan agreements with that express purpose in mind.
No matter how shiny and great your investment property is when you open it to the public, repairs will come up. Be sure you can include those costs in the price of the rental, while remaining competitive. If there are HOA fees or other property maintenance costs, consider the inflation to those year after year, as well. We’ve never heard of vendors wanting less money upon a contract renewal.
It’s often not considered up front, but it’s important to know that annual returns on investment properties can be negative. Major repairs to a rental or a down year in tourism can impact your bottom line in a big way. (See: COVID-19.) Consider the overall health of the rental market in your area. Could a single natural disaster or downturn in the market affect traffic to your community, and thus your rental? It’s important that you are personally able to cover the cost of the second mortgage and utilities of the second property, even if no one is in it for a while.
Just like your primary home, investment properties may not always appreciate in value. They are subject to a sometimes fickle rental market. For that and other reasons, investment property loans usually have higher interest rates and require a larger down payment than second home properties.
For more information, see our post: Top Things to Consider When Buying an Investment Property.
How do Investment Properties Affect Your Taxes?
The income you earn from an official rental property is subject to federal taxes. However, the IRS says you can deduct various costs related to a rental home, including repairs, utilities, advertising, taxes, insurance, and maintenance. But those deductions depend on how many days you spend in the house per year. The home must be rented more than 15 days per year, and you may only use the home yourself for 14 days or 10% of the number of days you rent the home (whichever is greater).
The intricacies of the tax code are worth considering before you make your investment purchase. Ask your Allen Tate/Beverly-Hanks REALTORⓇ or real estate tax specialist for more information.
Second Homes vs. Investment Properties: The Bottom Line
Lenders have different rules and rates for second homes as compared to investment properties. The IRS offers different benefits for each, as well as requiring different taxes for each. These rules and more will affect your wallet directly when making your purchase. So, it’s good to understand the intricacies of each property type up front.
Ready to Invest in a Vacation Home or a Vacation Rental? Discuss your real estate investment goals with your Allen Tate/Beverly-Hanks agent and mortgage lender. They will be able to help you weigh the short- and long-term benefits of your decision.
Contact your Allen Tate/Beverly-Hanks agent and mortgage lender today!
All real estate is local. In order to make confident real estate decisions, it’s important to have timely and neighborhood-specific information. Contact us today to speak with an Allen Tate/Beverly-Hanks real estate agent about purchasing a second home or investment properties in Western North Carolina. View all Allen Tate/Beverly-Hanks real estate listings.
One Response to “Should You Buy a Vacation Home or a Vacation Rental?: the Pros and Cons”
I wanted to thank you for this article about second homes and vacation rentals. It’s good to know that an investment property will have certain costs deducted from the rental home. It sounds important to learn what these deductions should be especially if they are different depending on where you live.