Inside Money: Can you afford a vacation home?

Talk about good timing.

Mortgage rates are at an all-time low, housing prices have yet to recover and sellers are motivated to unload unwanted properties. Maybe now is the perfect time to buy that Shore home you’ve always wanted. But before dipping your toes in the sand, you need to face the realities of owning a second home. You’re in for lots of extra costs. And if you’re not careful, there could be unintended tax consequences.

FINANCING THE HOME

If you’re thinking of paying cash, great. But remember you’ll be tying up a nice chunk of change in the property, and you may not be able to access the equity any time soon.
If you’re looking for a mortgage, you’ll need to decide if your new digs will be a vacation home or an investment property. The decision will impact your interest rate.

If the property will be used as a vacation home, you probably can get the same low mortgage rate available for a primary residence. If the home will be an investment property that you plan to rent, most lenders will offer rates 1.5 to 2 percent higher.

Another option is to tap the equity in your primary residence, taking a home loan or line of credit to fund the purchase. Before you do, however, remember that if you can’t make the payments, you’ll be putting your main home at risk.

“If you lose your job, you’re going to risk not only your second home but your primary residence, too,” says Michael Maye, a certified financial planner and certified public accountant with MJM Financial in Berkeley Heights.

THINK ABOUT CASH FLOW
Whichever way you finance the purchase, the money outlays aren’t over. To protect yourself, consider the following:

If you plan to rent the property, you need to be able to cover the bills should your renter bail. There are no guarantees, even if a property has a good rental history.

You will be maintaining two homes. If the air-conditioning breaks or the roof leaks at your investment property, you’re going to have to get it fixed, and fast, or you’ll risk losing your renters.

Depending on the location of your Shore property and how involved you want to be as a landlord, you may choose to hire a property management company to keep tabs on the home. You also will need to pay advertising fees to get potential renters to notice your property.

Financial planners recommend you keep a minimum of three to six months of living expenses in an emergency fund. However, with a second home, complete with its own mortgage, utility bills and more, your monthly expenses will rise. So, you’ll need to stash extra cash in an account to cover the bills should you lose your job.

VACATION HOME OR INVESTMENT PROPERTY?
Then there’s the IRS. You need to become intimate with the “14-day or 10-percent rule.”
You can rent your home for up to 14 days a year without having to declare the rent as income and the IRS will continue to consider the property a vacation home.

If you rent it out longer, the rent is taxable to you, but you also can deduct certain expenses.

If you personally use the home for more than 14 days a year or more than 10 percent of the number of days the home is rented out — whichever is more — the IRS considers the home a residence. If you use it less, it’s considered a rental property.

If it’s a rental property, you can deduct all your expenses, subject to IRS rules.

If it’s a mixed-use property (personal and rental), you can deduct expenses based on how many days the property is rented. For example, if you rent it out half the time, you can deduct a maximum of half the expenses (such as property taxes, mortgage interest and maintenance).

If rental expenses exceed rental income, those expenses are not fully deductible in the current year, but some of the rental expenses may be carried forward to next year, Maye says.

“If you itemize, you may still be able to deduct the personal portion mortgage interest, taxes and casualty insurance,” he adds.

Then there’s depreciation, which essentially lowers the cost-basis of a property.
“You’re allowed to recover the purchase price of the house or the structure, and that’s actually offsetting your rental income. However, any depreciation you take will lower the cost-basis, which potentially increases your tax liability when you sell the house,” Maye says.

The solution? Hire a good accountant and check out IRS Publication 527: Residential Rental Property at irs.gov.

WHEN YOU SELL 

You may keep your second home forever. But if you don’t, the Tax Assistance Act of 2008 changed the rules for excluding capital gains on home sales based on whether the property was a primary residence. The years in which the home was not a primary residence are disqualified for the capital gains exclusion, Maye says.

“For example, consider a married couple who rented their vacation home for three years and for the next two years moved into it as their primary residence,” he says. “Upon sale, their capital gains exclusion would be reduced for disqualifying use, and they would only get a $200,000 capital gain exclusion.”

Bottom line: If you buy a beach house, a good accountant should be your first guest.

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