Advice for Snowbirds Buying a Second Home
February 17, 2015 by Stephanie Potash
If you’re contemplating buying a second home by the ocean, mountains or warmer surroundings, you’re not alone. Approximately 717,000 vacation homes were purchased in 2013. That equals about 13 percent of the total homes bought last year — their highest market share since vacation home purchases peaked in 2006, according to the 2014 Investment and Vacation Home Buyers Survey published by the National Association of Realtors (NAR).
Unlike traditional home sales, which generally slow down during the holidays, the prime seasons for buying and selling vacation homes are fall and winter — when snowbirds flock to warmer weather and ski bunnies head to the slopes. Before you dive into vacation home ownership, here are some financial issues to consider.
Why Are You Buying?
When deciding whether a vacation home purchase is a smart financial move, first consider your motives. The No. 1 reason people plan to purchase a vacation home is for personal vacations and family retreats. If that’s your motive, realistically evaluate how much you’ll use it and whether you (and your family members) will want to return to the same locale, year after year.
Other buyers plan to use their vacation homes as their principal residences when they retire. If that’s your motive, evaluate the location’s medical care facilities, wheelchair and walker accessibility, proximity to children and grandchildren in your golden years, and state death tax laws that may be applied to your estate. Also consider whether the home itself is senior-friendly. Stairs, big yards and pools might appeal to a 43-year-old (the average age of vacation homebuyers in the 2014 NAR study). But these features can be too much for senior homeowners to manage independently.
Another reason for buying a vacation home is the investment opportunity, both in terms of monthly rental income and price appreciation. Online vacation rental sites make it easier than ever to rent a vacation home. And when you’re tired of renting, you can eventually sell the property, which should generally appreciate in value over the long run. The key to investing in real estate is to know local market values and trends. Ideally, you want to buy low and sell high.
Where Should You Buy?
Hot spots for vacation homes include Florida, Colorado and Arizona. You might prefer a less touristy, off-the-beaten-path locale to relax with family members. Or you might opt to be near the action to entice family members to visit — or to attract renters. Don’t rely on gut instinct. Let your motives for buying a vacation home and personal preferences guide your decision. Shoppers looking for a family retreat often bring relatives on house tours for a second opinion on their purchases.
Also factor rising travel costs into your feasibility analysis. Although 46 percent of vacation homes are within 100 miles of the owner’s principal residence, 34 percent are more than 500 miles away from home, according to the 2014 NAR study. If vacation homes are too far from principal residences, some buyers (and their family members) can’t justify the cost of airfare or gas to travel to the vacation home — then the property is underutilized and too often maintenance is neglected.
How Much Can You Afford?
Many vacation homebuyers want to take advantage of historically low mortgage interest rates. Interest rates, down payments and other mortgage terms vary depending on the property’s location and the borrower’s creditworthiness. Nationally, the current interest rate for a 30-year mortgage is near 4 percent on a 30-year mortgage (see right-hand box). Compared to first home buyers, second home buyers are expected to contribute a higher minimum down payment. The average down payment among vacation home buyers in the 2014 NAR study was 30 percent.
In addition, changes to the home mortgage lending regulations that were enacted by the Consumer Financial Protection Bureau in January 2014 generally limit a borrower’s total applicable payments (including student loans, credit card and car payments, housing costs, utilities and other recurring expenses) to 43 percent of pretax income.
Talk to a financial professional about your vacation home budget. They can help you crunch the numbers and get you prequalified before your search for the perfect vacation property starts.
What Operating Costs Will You Incur?
Surprisingly, 38 percent of vacation homebuyers pay cash, according to the 2014 NAR study. So mortgage costs are a moot point to many shoppers. But every wannabe vacation homeowner should consider ongoing costs, such as:
Property insurance. Typical homeowners insurance covers damages from fire, theft, vandalism and sometimes wind. Because of their locations — often near beaches and mountainsides — vacation homes may require special insurance coverage for location-specific risks, such as sinkholes, hurricanes, wind and floods. Modern homes that are made of more durable materials — such as cinder block, stucco and masonry — may be less expensive to insure.
Property taxes. A significant cost of owning real estate is property taxes. These vary substantially depending on where the property is located. Look up a home’s property tax history before making an offer. Taxes are usually based on a percentage of the home’s assessed value and paid in arrears, when the year that they cover is past or almost over. So if you’re buying new construction, ask your realtor about the taxes paid on nearby comparables to get an idea of how much your future property taxes on the home will be.
Homeowners association (HOA) dues. Many vacation home communities charge association dues, especially if they have a pool, guard house, golf course or health club facility. Most HOA dues also cover routine maintenance and insurance on common areas. Beware that some associations reserve the right to charge special assessments for unusual repairs and upgrades, however.
Property maintenance and management. Like all real property, vacation homes need to be maintained and monitored. Some vacation home owners pay a professional property manager (or simply a retired neighbor) to look after the property and help with renters while they’re away. There are also licensed, bonded and insurance home watch companies, which regularly visit and inspect properties. Other ongoing maintenance expenditures include repairs to structural components (roofs, windows and doors) and HVAC and electrical systems, utilities, landscaping and cleaning service fees, furniture and appliances, home décor, and upgrades to align the property to your evolving needs and preferences.
What Are the Other Tax Considerations?
If you use the vacation home strictly as a second home, not a rental property, and you itemize deductions on your personal tax return, you can generally deduct interest expense on up to $1.1 million of debt to acquire, build or substantially improve your first and second homes combined. This includes acquisition debt and home equity loans on these properties. You can also deduct property taxes on both homes, if you itemize deductions.
Important note: For 2014, the AGI thresholds for the itemized deduction phase-out rule are $254,200 for singles, $305,050 for married joint-filing couples, and $279,650 for heads of households. The total amount of your affected itemized deductions is reduced by 3 percent of the amount by which your AGI exceeds the applicable threshold. However, the total reduction cannot exceed 80 percent of the total affected deductions you started with.
When you sell a home, IRS rules allow an unmarried seller of a principal residence to exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. To qualify for this tax break, you generally must:
- Own the property for at least two years during the five year period ending on the sale date (the “ownership test”), and
- Use the property as a principal residence for at least two years during the same five year period, but periods of ownership and use need not overlap (the “use test”).
To be eligible for the maximum $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test. Additionally, if you excluded gain from an earlier principal residence sale, you generally must wait at least two years before taking advantage of the gain exclusion deal again. If you are a married joint filer, the $500,000 exclusion is only available if neither you nor your spouse claimed the exclusion privilege for an earlier sale within two years of the later sale.
Some retirees sell their principal residence and move into their vacation homes. But a gain on the sale of a vacation home that’s become a principal residence may not qualify for the federal home-sale exclusion — even if you’ve lived there for at least two of the last five years. Any period of time beginning in 2009 where you don’t use the vacation home as a principal residence is considered a period of “nonqualified use” and will require you to recognize a portion of the gain when you sell the property. The amount of the gain that’s subject to federal tax will be based on the ratio of time after 2008 that it was a second home or rental property (the period of nonqualified use) to the total period of ownership.
Complicated IRS rules and exceptions apply to calculating home-sale gains and exclusions, so be sure to consult with a tax professional when it comes time to sell your vacation home.
Is Vacation Home Ownership Right for You?
Owning a vacation home is more than a status symbol. It’s a reward for years of hard work and can be a legacy that’s handed down for future generations to enjoy. Smart vacation property investments factor in family member preferences, financing and maintenance costs, and tax issues. Consult your financial adviser for additional guidance on this important decision.