Can You Afford a Second Home?

When asked to describe their idea of living The Good Life, many investors tell me that they have a special place – a lake, mountain, beach, or city – that is near and dear to their heart. Their dream is to have a get away, not at retirement, but now to spend with their families and build the memories that will last a lifetime. If you find yourself constantly dreaming about that perfect Florida beach or the stillness of a snow-capped Colorado peak, it won’t be long before you find yourself Googling home prices in your favorite vacation town and thinking about the possibilities.

Having a second home is a wonderful thing, when done properly. It can also be stressful, time-consuming, and an enormous financial drain which can impact your financial stability and even your solvency. When the financial crisis hit, buyers of vacation properties disappeared, leaving cash-strapped owners in a tragic process of liquidating properties at enormous losses.

Today, prices have recovered and in many areas are back to fresh highs. Not only have bargains largely disappeared, prices have been driven up in popular locations by foreign investors who want to get money out of their own country and into the stability of US dollars. For many international investors, it is easier to buy US real estate than it would be to open a brokerage account in the US.

If you are contemplating buying a second home, be smart and make sure your decisions are based on a thorough and comprehensive examination of the financial details involved. For our financial planning process, that would mean adding in the realistic costs of a second home into our software and examining the results. Would the drain of a second home crowd out other cash flow goals such as retirement? Would you have to delay retirement by several years to keep your retirement success above 80 or 90 percent?

I own a second home, and have spoken with dozens of clients about their experiences over the years. Here’s my advice if you’re thinking of taking the plunge:

1) A second home is not an investment. It’s great if your Uncle made millions off the property he bought in Beaver Creek in 1976, but this is 2016. Very few people make money off their vacation properties, and even fewer actually consider their total costs of interest, taxes, insurance, upkeep, and utilities, when making a profit calculation. In other words, buying a condo for $400,000 and selling it for $450,000 five years later means you probably lost money. A 6% real estate commission would immediately reduce your proceeds from $450,000 to $423,000. Take out your other costs and you almost certainly have a negative return, even if you have a capital gain for tax purposes.

When we want something, our mind will go to great lengths to rationalize why it is a good idea. I once had a client bring me a spreadsheet showing the value of a condo in Hawaii increasing by 9% a year for the next 40 years. Why? Because he said it was a fact that condos in Hawaii increase by 9% every year.

I’m not saying a second home is a bad idea, but it’s best to not start with rose-colored glasses thinking that it will be a killer investment. Instead, examine the costs of a second home and calculate if you can afford this expense as part of your lifestyle. If, after many years of enjoyment, you were to turn an actual profit, consider yourself fortunate to have had such good luck.

2) If you are only going to be there two weeks a year, you will probably be better off staying at a hotel or rental rather than buying a property. This is not only likely to be the less expensive route, it also frees you from the mental and emotional drain of having a second home. Besides paying more bills, you have the difficulty and hassle of maintaining a property that is hundreds or thousands of miles away.

Don’t worry, there are management companies to look after your property, right? Yes, for a cost. Thinking that you can effortlessly rent out your vacation property when you are not there and it will pay for itself? While you may be able to offset your management fees and some other expenses, I have yet to meet anyone who actually pays their whole mortgage through renting. Instead, many drop out of the rental process altogether, citing time, added stress, damages, and wear and tear on their property, with minimal rent to show for it.

You should budget 1-2% of the purchase price per year to spend on repairs and maintenance. Some years you will spend less, but in other years, you may need to replace a roof, furnace, or other major item. Is your emergency fund big enough to cover two homes? There will be days when having two homes feels like you are trying to prove Murphy’s Law – if something can go wrong, it will!

If you want to save yourself the headache of getting that 11 pm call in December that the hot water heater is out, don’t be an absentee owner. Just take vacations. If after five years at the same beach, you decide you’d rather go to Europe next summer, you can change your plans and not feel like you are obligated to go to your second home year after year. In fact, behavioral finance suggests that you may have more memories and find more fulfillment from taking 10 different vacations rather than going to the same place for 10 summers in a row.

3) On taxes and finances, a few points to consider:

  • You can deduct mortgage interest and property taxes on a second home. These are itemized deductions.
  • Only your primary residence is eligible for a capital gains exclusion of $250,000 ($500,000 if married). For a second home, keep records of any capital improvements which would increase your cost basis. If you have a very large potential capital gain, you can receive the primary residence capital gains exclusion by making the property your primary residence for two years. As long as a property was your primary residence for two of the past five years, you are eligible. Keep capital gains records until seven years after the sale.
  • You can rent out a primary or second home for 14 days a year tax-free. You don’t even have to report this income!
  • If you use the property personally for more than 14 days or more than 10% of the total rental days per year, it is considered a personal residence and you can only deduct rental expenses up to the amount of rental income.
  • If your personal use of the property is less than 14 days AND less than 10% of the total rental days, the property is considered a rental property (a business), and not a second home. You can deduct losses and may depreciate the property. Note that days you spend full-time on repairs and maintenance (but not improvements) are not considered personal use days, even if the rest of your family is enjoying recreation that day.
  • If you let others stay for free, or below fair rental price, or give away days (even to a charity auction), those are considered personal use days.
  • Before you rent, make sure your insurance covers renting. Talk with owners of similar properties if you want a realistic idea of how many days of your property might be rented each season. Do your homework before you buy.
  • In Texas, primary residences are creditor protected, 1 acre in town or 100 acres rural, with no limit on value. These are doubled for married couples. Second homes are not creditor protected. Which mortgage should you pay off first? Probably your primary residence.

Link: IRS Publication 527, Residential Rental Property Including Rental of Vacation Homes.

If all this makes your head hurt, you may be happier keeping your life simple and just enjoying your vacations without owning a second home. You cannot ask your accountant to sort this all out at the end of the year if you haven’t kept complete records of use/rental days and expenses.

4) When it comes to affordability, don’t let a mortgage broker tell you how much you can afford. They calculate the maximum the bank is willing to lend you; they don’t care about your other priorities like contributing to your 401(k) or paying for your kid’s college. If you want to know what you can afford and still accomplish your other goals, you need to do a financial plan. That’s where I can help.

5) Not surprisingly, the vast majority of people I have met who purchased a timeshare have been frustrated and regretted the decision. Similarly, friends who purchase property together often find things become less than cordial when disagreements arise over use, expenses, or maintenance.

Link: HGTV Top 10 Things to Know About Buying a Second Home