Four Financial and Tax Considerations for Buying a Vacation Home

You just returned from a fantastic vacation at your favorite resort—one you enjoy so much that you are considering buying a vacation home in the area. As you evaluate this new and exciting opportunity, there are several things to consider. Our team is here to help you make an informed decision. 

You need to consider the purchase price of the home as well as annual property taxes, HOA fees, management fees, insurance, and maintenance. Depending on the location, insurance, and other annual costs can be much higher than you might initially think (i.e., if near an ocean, hurricane-prone region, mountainous region, etc.). 

Interest rates will likely be higher for second homes when compared to primary residences. However, you may be able to alleviate the higher cost of borrowing by taking out a Home Equity Line of Credit (HELOC) on your personal residence, using a portion of your after-tax investment accounts as a down payment, or borrowing against a portion of a taxable investment account (non-retirement funds) and using the account as collateral. 

If you have the means to use cash to cover the full purchase, compare the interest rate you can secure from your mortgage company against your expected investment return rate on the funds. You might benefit financially by leaving your investment portfolio intact and borrowing for the vacation home purchase. There may be a tax benefit to financing a portion or all of the purchase. Mortgage interest on a second home is sometimes tax deductible. Contact your CPA for limits and restrictions. 

Renting your vacation home can make the purchase more attractive by providing you with cash flow to use toward expenses associated with the home. If your vacation home is located near a seasonal recreation area, the benefits could be significant. 

For tax purposes, if you rent your vacation home for less than 15 days per year, the rental income is nontaxable, and rental expenses are nondeductible. Mortgage interest and property taxes would be deductible as itemized deductions, subject to certain limits. 

If you rent your vacation home for more than 15 days per year, the record-keeping and tax consequences become more complex. All income is reportable, and expenses must be allocated between rental and personal use. The rental portion of mortgage interest and property taxes are deducted to offset rental income, with the personal portion added to itemized deductions. Other deductions such as maintenance, HOA fees, and depreciation may reduce your taxable rental income but cannot produce a loss. If the rental has limited personal use, It is possible to carry losses forward to future years. The tax rules related to rental properties are complex, so you should discuss your expected personal and rental use with your CPA before purchasing. 

If you see yourself owning the property long-term, think about whether the location and layout of the home will be consistent with your future lifestyle. When retired, you may not want to deal with inclement weather, a steep driveway, or stairs. 

When selling your vacation home, tax consequences are not as beneficial as selling your personal residence. The net gain from the sale is taxed at capital gain rates, which can vary from 15% to 23.8% (if held long-term), with state taxes producing additional liability. You can deduct selling expenses and cost basis (purchase price plus improvements) from the gross sales price to arrive at the net taxable gain. In some cases, it might make sense to use the property as your primary residence for at least two of the five years before selling, which could allow the exclusion of up to $500,000 in taxable gains for a married couple. 

Before you purchase a second home, evaluate the potential impact on your long-term financial plan. Will the purchase absorb a portion of your nest egg and require you to work longer? Even if owning a vacation home is a long-term goal, will ownership and maintenance expenses result in reduced savings for retirement that impact your asset pool downstream? And while a vacation home is an asset, it’s generally not very liquid. Will you still have sufficient liquidity to meet emergency needs? 

Before making a purchase, we recommend consulting with your advisory team to assess the impact on your tax situation and financial plan. If you’re purchasing outside the United States, be sure to contact your advisor and attorney for tax considerations and legal implications.