Skip to main content

Buying a Second Home: Vacation Home or Rental Property?

Depending on what you’re using it for, you can receive several financial benefits by buying a second home. If you were to turn it into a rental property, for instance, you’d get an extra source of income. You’d also have tax advantages because you could deduct your taxes from the property’s income instead of your own.However, you also need to consider that mortgage rates typically run higher for second homes compared to your primary residence. The rates for second homes are usually higher by less than .50 percent and about .50 to .75 percent higher for investment properties. If you’re thinking of buying a second house, you need to be aware of the pros, cons, and financial considerations involved in the purchase.

Vacation Home

Buying a vacation property can be a wise move if you visit that location frequently throughout the year. An Aspen or Hamptons home, for instance, is a worthwhile investment if you spend two months there each year. Your annual mortgage payments on the property could be almost equivalent to what you pay for two months of rent.Additionally, you’ll be building your equity in the house over time instead of just giving your money to someone else.You can also rent out your vacation home when you’re not using it. As long as you’re renting it for less than 15 days, you won’t have to report your income to the IRS. Keep in mind, though, that if you spend less than two weeks in your vacation home and rent it for the rest of the year, the IRS will consider it as an investment property. This means you have to report your earnings.Below are some financial factors to consider before buying a vacation home.

  1. Potential Tax Breaks

You can receive tax breaks for mortgage interest and property taxes if you’re using your second home primarily as a vacation home. You can deduct up to $10,000 of your real estate, state, and local taxes on your vacation home – $5,000 if you’re married and filing separately.You’ll need to keep in mind, however, that the deduction limit is low. Many people who buy a second home may already exceed the limit with their first home, so they don’t get additional tax savings from their second home.It’s also important to be aware of the tax break you won’t get on a vacation home. When you sell a primary residence, you can exclude as much as $250,000 in capital gains from your taxes. If, for example, you paid $400,000 for your primary home and sold it for $500,000, you don’t have to pay any tax on your profit.On the other hand, selling a vacation home for the same figures doesn’t afford you the same advantage. Your $100,000 will be taxable.

  1. Other Expenses

Owning a second home involves many expenses apart from your mortgage and taxes. You’ll have to pay for insurance, utilities, and homeowners association dues and memberships. The location of your property can also balloon your expenses, especially if you’re buying in a popular vacation spot.You’ll need to spend money on property maintenance, too. Since the house will likely be unoccupied for most of the year, you’ll need to hire property management professionals like handymen, painters, gardeners, and even snow-shovelers. These services can add up to thousands of dollars a year.There’s also the matter of security. It’s smart to beef up your second home’s security system, so you can keep an eye on it even when you’re not around. Invest in outdoor surveillance cameras, a video doorbell, and a home alarm system that will alert the local police if a breach occurs.Equipment costs vary, but they are generally more expensive if you’re getting professional installation and 24/7 monitoring services.

  1. Vacation Home Insurance

Buying a second home means purchasing an additional set of insurance policies for coverage. You need the right insurance for your vacation home because you’ll be leaving it empty for most of the year, making it vulnerable to burglary and negligence-caused damage.A vacation home insurance policy should be enough to cover a home you own but don’t live in full-time. This type of policy differs from traditional homeowners insurance in that it only protects against named perils. A named perils insurance policy provides coverage only for losses caused by events or risks identified in your plan.Typical vacation home insurance policies cover damage from fire and smoke, lightning, explosions, and theft. Properties located in areas prone to flooding, earthquakes, and hurricanes are subject to higher premiums because they’re more likely to be damaged.Note that insurance rates are generally higher for second homes. Insurers see them as riskier assets because of their vulnerability to break-ins and property damage. Moreover, if you’re planning to use the house for short-term rentals, you’ll also need to get short-term rental insurance.

Rental Property

rental propertyRenting out your second house helps cover the expenses of buying the property. You can use your profit to pay your mortgage and have the renter pay for the utilities and some of the property upkeep expenses.Being a landlord, however, entails certain responsibilities to your property and your tenants. You need to comply with rental laws and other requirements to make your property safe for your tenants. You’re also responsible for the maintenance of the property and its utilities, meaning you’ll have to attend to issues regarding water, heat, and other services agreed upon in the lease.Here are some of the financial aspects of owning a rental property that you should consider.

  1. Tax Deductions

Owning a rental property can generate some great tax breaks. For one, the mortgage interest and property tax of your rental unit are tax-deductible because they’re technically business expenses. You need to remember to file the deduction on your IRS Schedule E (Form 1040) when you file your tax return.Rental properties are business assets that depreciate, meaning their worth decreases over time. You can deduct that depreciation each year on your tax return. The calculation is complicated, though, so it’s recommended to have a tax specialist handle it for you.Rental expenses, such as repairs, maintenance, and other operating costs, are also tax-deductible. Some examples are fixing busted garbage disposals, patching holes in the wall, or replacing the light bulbs. Only necessary expenses can be deducted, though, so the cost of improvements isn’t included.

  1. Rental Real Estate Loss Allowance

This allowance gives you a federal tax deduction of $25,000 per year in losses from rental properties. You can deduct the loss from other income sources you have.Rental real estate loss allowance, however, is subject to passive loss rules. Rental losses are always considered passive losses, which can only be deducted from a passive income. Passive income is the income you earn from activities you don’t “materially participate” in, meaning you spend less than 500 hours on it each year.Investments, rental properties, and peer-to-peer lending are some common sources of passive income.In short, you won’t be able to deduct your rental losses until you have enough passive income to offset the amount.There are exceptions to the passive loss rule, though. You can qualify for the allowance if your adjusted gross income doesn’t exceed $100,000. You also need to be actively participating in rental activities. This means having more than a 10 percent ownership interest in the property and participating in meaningful management decisions regarding the rental.Your deductible losses, however, may be limited if your rental expenses exceed your rental income, as indicated in the Passive Activity and At-Risk Rules.

  1. Income and Expenses Reporting

You need to report all your rental income using Schedule E. List your expenses, total income, losses, and depreciation for each rental property you own.If you have more than three rental properties, attach as many Form 1040s to list all your properties. Complete lines 1 and 2 for each property, but fill out the “Totals” column only on one form. The figure you’ll put in this column should be the combined totals of all your Schedules E.Make sure to keep records of your rental activities, including financial statements, receipts, and tax return documents. You’ll need these in case you’re selected for audit. If you’re audited and cannot provide evidence to support the items you reported on your tax returns, you might be subjected to penalties and additional taxes.

  1. Landlord Insurance

You’ll need landlord insurance to cover the unique risks of renting out your property for prolonged periods. The coverage varies per insurer, but most policies cover damage to the structure of your property, damage to items contained inside the house, and rental income loss.Rental property insurance often includes landlord liability protection. This clause helps you pay for someone’s medical bills or legal expenses if they’re injured on your rental property and you’re found responsible.Let’s say, for example, your tenant fell down the stairs and the court determined that you failed to maintain the railings, which led to the accident. You would be held responsible for your tenant’s recovery expenses. Your landlord liability coverage can help pay for those expenses, as long as the costs are within your policy’s limits.

Buying a Second Home

As you can see, buying a second home is a huge financial decision regardless of whether you’re using it as a vacation home or a rental property. Do your real estate homework first and learn more about the location you’re eyeing and the financial responsibilities involved in buying a second house. Use online mortgage calculators to get an estimate on your down payment and monthly costs.Make sure to seek the advice of an expert real estate agent to make the right choice. If you need guidance in buying a second home, look no further than Cami Jones Collaborative. Named one of 2018’s top residential real estate agents and teams in Kansas City by the Kansas City Business Journal, we help clients in all their home buying and selling needs.With Cami Jones Collaborative, you get more in-depth services than the average agent. We use our advanced market research strategies and fearless negotiation skills to help you find your dream home. You’ll get a bespoke, full-service experience that takes care of your sale or purchase from beginning to end, taking the stress out of the entire experience.Planning to buy a second home in Kansas City? Call us at (913) 521-5584 or fill out our online form to book an appointment today.

Leave a Reply