Vacation and Rental Home Financing

Purchasing vacation property is one way of investing in real estate. Properties in many areas can be purchased and rented out on a short-term basis to vacationers. Most real estate investments are growth oriented, meaning that the return on your investment is based on how much your property increases in value from the time you purchase it until the time you sell it. However, when you purchase rental property (either residential or vacation), your focus will be on current income and cash flow. Although you might someday sell the property at a profit, the greater part of your return will likely come from rental income. For this reason, vacation rentals are typically long-term investments.

What are the risks?

Although vacation rental property is not as speculative as some real estate investments, substantial risk is still associated with investing in vacation rentals. In particular, vacation property investments are subject to market risk and liquidity risk. Your chosen location could unexpectedly fall out of favor with the vacationing public, causing your rental income and property values to plummet. A poor economy could cause more people to cut back on vacation plans, leaving you with fewer rentals. Changes in tax laws could reduce the favorable tax treatment of rental property. Should you find yourself with an unexpected cash need, you will probably not be able to sell your vacation property. Before purchasing property as a vacation rental, you should evaluate your ability to deal with these risks.

When can it be used?
Vacation rentals are a specialized field. In order to be successful, you must have (or be willing to work on acquiring) knowledge of the real estate business as a whole. Books and seminars are a good start. You might also want to talk to others who have made successful investments in vacation rental property. Investing in vacation rentals also requires common sense, in that you must have the foresight to find the right location. Finding good properties in up-and-coming vacation spots takes more than just luck. It’s a product of diligently studying an area and recognizing its trends. You must also be a good judge of character when it comes to choosing professional property managers (if you choose to use them). However, one of the most important factors is determination. You may not realize it if you are just starting out, but it takes a serious commitment to keep your vacation rentals in top condition, so you can continue to attract vacationers and increase your property value.

Like all real estate, vacation rentals can be risky investments. Before you consider this type of investment, you must evaluate your ability to deal with the risks and responsibilities associated with vacation rentals. In addition, asking yourself some of the following questions may help you evaluate the appropriateness of this investment.  

  • Do I have the financial backing required to purchase investment property?
  • If not, is my credit rating good enough to secure financing?
  • Do I have the ability and the resources to use my own money if necessary to help the investment survive?
  • Would my life’s savings be in jeopardy if I needed cash to help pay bills for the investment property?
  • Would I have sufficient income to cover the property’s expenses until rental income levels returned to normal?
  • Would worrying about my vacation rental property interfere with other aspects of my life?
  • If I decide to go into this business and fail, would I be all right financially? Emotionally?


Strengths
1) Rental property receives favorable tax treatment. As an income-producing, tangible property, it is also considered a business property. If your vacation property is used exclusively for rental purposes, it qualifies for certain favorable tax treatment. Your mortgage interest, property taxes, insurance, maintenance, and other expenses are typically tax deductible (consult with a tax advisor). However, if you use the property for personal use as well as renting it out, these tax advantages decrease accordingly. Property depreciation is also generally deductible.

2) A variety of property types and locations provide flexibility. When you purchase vacation rentals, you can choose from a wide variety of property types and locations. Your choices range from a beach front house in Key West to a ski chalet in Colorado, to a three-season A-frame in the Adirondacks, to a townhouse in New Orleans, and more. Perhaps you’ll want to purchase property near your home, so you can conveniently make inspections and repairs. Or maybe you’ve found an idyllic vacation spot that you and your family enjoy, and you want to purchase property near this paradise. In any case, the options are virtually endless when it comes to choosing vacation rental investment property.

3) Vacation rentals provide both current income and the potential for capital gains: As mentioned, most of the return on your vacation rental investment will be current income in the form of rent payments. However, rental property also has the potential for capital gains because there is a chance that you can eventually sell the property for more than your original purchase price. By contrast, most real estate investments provide an opportunity for capital gains, but little current income.

Trade-offs
1) Real estate can be a highly speculative investment: It is imperative that you understand the risks you are undertaking when you invest in real estate. There is no guarantee you will realize a profit on a real estate investment. In fact, there is no guarantee your property will even retain its current value. What makes real estate investing potentially hazardous is that so many of the factors that determine the success or failure of a given real estate investment are outside of the investor’s control. Changes in the tax code could reduce or eliminate the tax advantages of real estate investing. Economic changes in an area (e.g., the failure of a major business or the closing of a military base) can adversely affect property values as the real estate market is flooded. Other economic factors (e.g., high unemployment or even high gas prices) can directly affect the vacation rental industry by discouraging vacationers from taking expensive trips to remote destinations. Natural phenomena (e.g., weather, lack of snowfall, forest fires, and beach erosion) can affect the demand for seasonal rentals. Financial markets can also affect the value of real estate investments as interest rates fluctuate. These are just a few of the many risks to consider if you are thinking about investing in real estate.

2) Vacation property requires near-constant attention: Vacation property is not a "buy it and forget it" investment. 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 and maintain the property yourself, it is a major time commitment and calls for basic handyman skills. If your hire professionals, you give up a certain degree of control, and their salaries will cut into your profits.

3) Property values, occupancy, and rental income typically vary with the popularity of the area: Since the majority of your return from an investment in vacation rental property comes from rental income, it is important to keep your occupancy rates as high as possible. Of course, this may be much more difficult if the area you choose decreases in popularity. And unfortunately, the future popularity of an area is largely outside of your control. Political and economic changes can adversely affect the popularity of a given vacation spot, as can unexpected events such as hurricanes, forest fires, and other natural disasters. A decline in popularity can also affect your property value and could be devastating when you eventually decide to sell the property. In fact, if the popularity of the area declines enough, you may find yourself unable to sell the property at all. Once a vacation spot falls from public favor, it may be difficult to find a buyer at any price.

4) Vacation rentals are not a liquid investment: Like all real estate, vacation rentals are relatively difficult to sell in a hurry, and there is little certainty about the selling price you will receive if you do manage to find a quick buyer. Unlike the stock market and many other securities markets, there is no established national market for real estate trading. If you choose your property wisely and manage it well, you may have a steady stream of rental income, but you will probably not be able to sell the property quickly if an unexpected cash need arises. Other types of investments, such as stocks, bonds, and other short-term securities, should be included in a balanced portfolio to provide adequate liquidity.

5) Investing in real estate typically requires a large outlay of capital: Many investors do not even consider getting into real estate, because of the relatively large sums of money necessary to acquire and maintain property. This capital requirement also contributes to real estate’s poor liquidity. This disadvantage works in two ways: first, by making it difficult for you to enter the real estate game yourself, and second, by making it difficult to find a buyer who can get you out of the game when you’re ready to quit. If you are not prepared to lay out a significant amount of money for an individual real estate investment (or you are not willing to secure the necessary financing), you might want to consider a different type of venture, such as a real estate investment trust (REIT) or a real estate partnership.

Choose the vacation property
Your vacation rental property must be chosen with care. Remember, today’s vacation mecca could be tomorrow’s ghost town. Beach front condos and ski chalets are typically popular, but vacationers are fickle. Duration of the vacation season is also an important consideration. Your rental opportunities are probably greater with a Florida beach home than with a condo in Vermont (but don’t forget to consider the possibility of hurricane damage if you buy coastal property). In other words, there is no perfect vacation rental property, but it is important to do your homework before making a purchase.

Arrange financing for the purchase (if necessary)

If you are purchasing vacation rental property, you will probably need a mortgage. Even if you have resources available to make the purchase, taking a mortgage is typically advantageous because the mortgage interest is generally tax deductible as a business expense. Many different types of mortgages can suit your specific needs, although not all types of mortgages are available from all lenders, and many are not appropriate for investment property.

Decide on form of ownership

If you are purchasing property by yourself, your only real choice (unless you incorporate) is sole ownership. However, if you are buying property with another person or persons (e.g., your spouse, your children, or a group of associates), you have several options with regard to form of ownership. You may choose to own the property as joint tenants, as tenants in common, or as tenants by the entirety. Each of these forms of ownership has certain advantages and disadvantages, depending on your situation.

Note: It is also possible to form a business entity (e.g., partnership, limited liability company) to own property.


Arrange for continuing management and maintenance of property

You might decide that you can handle the management of your vacation rental yourself, especially if you own only a few properties, and if your properties are located close together. If you choose to manage your properties yourself, make sure you understand the task you are undertaking. Make sure your schedule can accommodate the time commitment. Some of the necessary tasks include:

  • Publicizing your property
  • Talking to prospective renters
  • Checking references and credit reports
  • Sending and receiving correspondences
  • Setting and collecting rents
  • Cleaning up between renters
  • Making frequent inspections
  • Arranging for repairs and maintenance
  • Making property improvements
  • Maintaining adequate and appropriate insurance
  • Paying property taxes

Professional management may be necessary if you don’t have the time or inclination for these necessary activities, or if you own many properties in diverse locations. Professional managers may also be helpful if you are uncertain about fair market rents in the area where you have purchased property. Hiring professional managers means you don’t have as much to do to keep your vacation rental functioning, but it also means you have less control over your property, and your profits will be reduced by the salaries of your managers. Finding competent and reliable property managers can be a challenge, so make sure you take this task seriously.

Tax considerations
Rental property receives favorable tax treatment and vacation property used strictly for rental purposes is considered rental property. As such, it receives certain enticing tax treatment.

  • Business expenses (e.g., mortgage interest, property taxes, insurance, and maintenance) can be deducted against rental income received
  • If the total expenses are less than the gross rental income, the resulting profit is taxable income
  • If the total expenses exceed gross rental income, the resulting loss can be used to offset income from other investments

Personal usage of rental property may reduce or eliminate tax advantages

You might consider purchasing vacation rental property because you can use it yourself whenever it’s not rented out. Think again! If you want to take advantage of the special tax treatment of rental property, your personal usage of the property is limited. Tax treatment of rental property is based on both the amount of personal use and the amount of time it is rented out during any given year. The basic rules are as follows:

  • If you rent out a vacation property for fewer than 15 days in a given year, the property is considered a personal vacation home, regardless of the amount of personal use. Mortgage interest and property taxes are deductible, but other expenses are not.
  • If you rent out a vacation property for at least 15 days in a given year and your personal usage is limited to 14 days or 10 percent of the time it is rented (whichever is greater), then the property is considered rental property. Tax treatment of rental property is described above.
  • If you rent out a vacation property for at least 15 days in a given year, but your personal usage exceeds the 14-day/10 percent rule, the property is considered a second home. This is the least desirable scenario. Mortgage interest, property taxes, and other expenses are deductible only to the extent of your rental income. If expenses exceed rental income, the loss may not be used to offset other income.

Repairs and improvements are not the same in the eyes of the IRS

It is important to understand all of the tax deductions associated with rental property. One subtle but important rule to know is that repairs and improvements are treated differently in the eyes of the IRS. 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 like any other business expense. 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 investments and are thus recovered through depreciation.

Property depreciation is deductible

Another tax benefit of vacation rental property is the deductibility of depreciation. Rental property is assumed to decrease in value over the years, due to wear-and-tear and other factors. Although this is not necessarily the case, you are allowed to deduct depreciation as a way to recover this assumed loss of value. Rental houses and apartments placed in service after January 1, 1987, depreciate on a straight-line basis over 27.5 years (approximately 3.63 percent per year). Thus, if you purchase vacation rental property this year for $137,500, your depreciation deduction would be $5,000 per year for the next 27.5 years.

Tip: Certain qualifying property may be entitled to a special 30 percent additional first-year depreciation deduction.

Capital gains tax liability may result from eventual sale of rental property

Because your vacation rental is a capital asset, you may be required to pay capital gains tax when you eventually sell it. In general terms, if you sell the property for more than you paid for it (or your basis in the property), you have realized a capital gain. If this gain cannot be offset by capital losses, you will have to pay capital gains tax on this amount.