Investing in Vacation Properties
We don’t normally think of vacation properties as investments, but at certain times and under certain circumstances, they can be one of the best investments you can make. This can very well be one of those times.
What Are the Advantages?
Apart from the obvious benefits of having a permanent vacation destination, as well as a familiar place to escape to and relax, owning a vacation property has other advantages.
An Investment With a Tangible Use
Much like your primary residence, a vacation property is an asset that has practical uses. You're not just sitting back waiting for it to provide income or to rise in value, but you're getting a present use out of it in the form of a vacation escape.
You Can Rent It Out if You Need Extra Income
You can keep the property primarily as a vacation home, but if money ever gets tight you can always rent it out for income. And since it is a second home that will be easier and less disruptive to do than it would be for your primary residence.
It Will Likely Rise in Value in the Long Term
Like most forms of real estate, vacation properties will rise in value over time. And during speculative periods in the real estate market, the value increase on vacation property can be spectacular.
It's a Potential Retirement Home
Vacation property can provide the owner with the ability to “test drive” a home as a potential retirement home. You can buy the house early in life, get comfortable with the area it's located in, and payoff the mortgage in time for retirement. That will free you up to sell your primary residence to increase your retirement portfolio. In that way a major component of your retirement plan will be taken care of while you're enjoying the home.
Vacation Property Prices Are Depressed in Much of the Country
This is bad news if you own a vacation property in an area where real estate prices have been particularly hard-hit. But if you're looking to buy a vacation property in such an area, the timing couldn't be better. In many traditional vacation property hotspots, like Florida, Nevada, and Arizona, prices are now well below their peak levels. If you're a buyer, entire vacation property markets are now on sale!
What Are the Risks?
Vacation property tends to have wider price swings than other property types. During real estate booms, it can rise in price much faster than residential property, not the least of which because it tends to attract more affluent buyers. But in down markets prices can fall faster too.
Vacation property is luxury real estate, not the basic roof-over-your head type. It’s more discretionary than it is necessary, and that means the market for it can dry up much more quickly. When it does, prices can crash even when the general housing market is stable.
It’s often located in environmentally volatile areas that can physically threaten not just the property itself but the entire surrounding community. Waterfront locations are common, which opens the possibility of flooding or ocean storms. A single severe coastal storm could drop property values overnight.
Income Tax Considerations
The Internal Revenue Service (IRS) has very specific rules in regard to vacation properties. The dividing line between classifying the property as a vacation home or as an investment property is defined by the number of days that you as the property owner occupy it for personal use.
If you use the property for personal use for more than the greater of 14 days, or more than 10% of the number of days it’s rented out, it is considered a vacation property. If the property is rented out for more than 14 days, it’s considered an investment property.
If the property qualifies as a vacation home, you can deduct mortgage interest and real estate taxes on Schedule A of your income tax return, just as you would for your primary residence. Other expenses, such as insurance, repairs and maintenance and condo fees will not be deductible.
If the house qualifies as an investment property, you will be able to deduct all expenses connected with the property at least up to the amount of rental income received from it.
You may be able to deduct net losses on the property, but that will depend on the amount you have invested in the property that’s considered “at risk”, whether or not your participation in the investment is considered “passive“, and the level of your modified adjusted gross income. Translation: consult your tax preparer to determine the limit of rental real estate losses you can deduct.
Vacation Property and Foreign Money
There's one more aspect of vacation property that rates its own discussion, especially now. Earlier we discussed how vacation property prices can rise faster than the overall market during speculative booms. Part of the reason for this is foreign money.
The US has traditionally been a haven for foreign money. Wealthy foreigners often move their money here in order to escape either economic declines or political instability in their home countries. When they do, their money often flows into real estate, and much of that goes into vacation property.
There are several reasons for this. For one, foreigners are looking for a second home situation and vacation properties are perfect for that. For another, foreigners often buy into the US vacation property market after price crashes. Still another reason is that they want to live in homes that are located in areas that they've seen in the movies and on TV. Those are often vacation havens in places like Florida, California and Arizona.
Right now the vacation property market in the United States in general is depressed. At the same time, people from China and much of the developing world are pouring their money into US real estate looking for an escape hatch in a stable place. Well-to-do Europeans are also looking to move money into the US in order to escape the declining economic fortunes there.
What this all means is that we now have a rare combination of events that favor vacation property. If you're willing to accept and deal with the risks of investing in vacation properties, now could be a once-in-a-lifetime opportunity.
Readers: What do you think? Do you think owning a vacation property is a good idea?
As you mentioned, when you own a vacation residence, you can rent it out when you are not using it to earn a little extra income. My parents travel to the same spot every year for their vacation, and now they are considering purchasing a vacation home there. I will have to mention this to them, and see what they think.
Investment in a vacation home may indeed be a wise idea, as long as you are not talking about time-shares. Time-shares have proven time and again to be very unwise investments. They are notoriously hard to unload in difficult times, leaving the owners stuck with mortgage payments beyond their means. Vacation properties, or second homes, may be less onerous. What strategies can investors take to ensure their vacation home property remains an asset rather than a liability?
Hi Thomas–Timeshares are vacations arrangements, not investments, so I completely agree. Best way to ensure a vacation home remains an asset? Buy after a price collapse. There’s really no way to guarantee any kind of investment, but you can increase your chances of success by buying smart. Most people buy at market tops, and that’s why so many of them get burned.
This whole subject is worth thinking hard about for many couples. There are decent, small houses in nice parts of the country that are going for less than $100,000. Is it a place you could move to in your 60s? If you sell your permanent residence you get tax free up to $500,000 for a couple. You can live off that, have essentially zero income if your investments are structured right and do a nice Roth conversion of IRA assets and pay minimal taxes. There are a lot of possibilities that open up. The fact that there are really good houses available presents an opportunity. I wouldn’t just limit it strictly to vacation property. I believe for example you could do what I describe by buying a small house 40-45 minutes from Nags Head N.C.
I’d be careful about buying a house near, but not in a resort community. They’re cheaper, sure, but they are because they lack the specific location and amentities that resort communities offer.
We have some friends with houses at the Jersey shore. Aside from being slammed by Sandy recently, they’re all heavily cash flow negative at purchase. You have to really just love the shore that much and plan on using it 20 years down the road after renting it out all season at a slight loss while at least paying down the mortgage. Our friends only get down there for off-season stuff and have to rent it the rest of the time while losing a few grand a year along the way. I guess long-long term it will be worth it to them. I’d sooner just rent 1-2 weeks a year and avoid the hassle.
They may be losing some money each year, but once the mortgage is paid they’ll have a major asset. The way they’re doing it is almost like an IRA. All the payoff is at the end.
I owned a vacation property with 2 of my friends for 10 years. It was a condo in Mammoth, California. One of the best ski areas in the country. We earned a 10% return, but cash flow was near zero. There were some years there was no snow or a late start of the season. There were repairs and remodeling too. We made our return on the sale.
There’s no question that vacation property is higher risk than more traditional residential real estate. But it’s also potentially more profitable for all the same reasons, as you found out on the sale of the property.
Thinking about a vacation home for retirement is a good idea. My wife and I are empty nesters. The house that was the right size with 3 kids is now much too big. We have a place in the mountains in Virginia we are moving to. The sale of our primary residence gives us a nice part of our retirement since it is tax free. We plan to use the cabin as a base as we do some RVing.
In terms of timing I think now is a great time for those in their 40s/50s to buy a place. But again, as the post recommends, look at it from the perspective of “could we live here?”. It is just another choice – you obviously could sell it as well.
I agree, 40s and 50s are the time to buy a vacation-to-retirement home. Not only will that give you time to get to know the house and the area but also to pay off any financing on it. A mortgage free vacation home can be the perfect retirement home.
Over 20 years ago, my in-laws bought new construction time-share on the beach in the Caribbean, it was not seen as an investment as much as a vacation home, they started with 2 weeks and are now up to 8 with the last week being purchased this past year. Time shares are not generally good investments, however this happened to turn out very well, the first weeks the purchased were about $12k and could currently be sold for about $28k. The most recent week they bought which was a very good deal at about $23k (it is a slightly less desirable unit then the first weeks they purchased it is set further back form the ocean), the added value is they own the previous two weeks in that unit. They own 3 units 2 of them for 3 weeks and 1 for 2 weeks, multiple weeks in the same unit are worth a premium. The unit they own for 2 weeks is during Christmas and New Years and are worth more due to the holidays, they are also Penthouse units. Also when you own the last week of the year every 7 years you get a bonus week, 52 weeks of 7 days is 364 not 365, with leap years the calendar accrues an extra week every 6 to 7 years, it belongs to the owner of week 52.
They can easily sell all of their units for about a 70% return over the 20 years, but very few people sell, we see the same people year after year when we vacation.
I would like to buy a vacation property myself over the next year or so in one of the US distressed markets, most likely Florida due to is proximity (I live in NY). Distressed markets and low interest rates do make vacation properties seem like a good opportunity for long term gains.
Hi Jay–Time shares are really a different animal, and not investments in any sense of the term. But you hit the nail on the head with the combination of low interest rates and depressed vacation property prices. That’s a once in a lifetime opportunity.