June is Investment Properties and Second Homes Month here at Inman. We’ll explore everything including top investor insights, the latest at Airbnb and Vrbo, and the surprising locales emerging as investor hot spots across the country.
This article was last updated June 10, 2024.
Helping a client purchase that lake place, ski condo or sunny snowbird destination?
Or sometimes even more complex, a client considering selling the family retreat?
Vacation homes can be a lifelong goal for many families, but along with the fond memories made come a slew of financial and emotional implications.
And while it is not your job to know every line of the tax code, you are uniquely positioned as their agent to help them identify areas where they should give extra consideration or even loop in other members of their financial team for niche expertise.
So, if you have a client buying or selling a vacation home, here are the financial aspects they need to know.
Hidden expenses
The total cost of owning a vacation home is typically the driving factor in how much vacation home to purchase or for a client deciding to sell a property.
While we all know that homeownership costs more than simply principal and interest payments to the bank, the level to which additional expenses can mount for a vacation home can be surprising to homeowners.
Here are some common hidden expenses your clients should be aware of:
- Higher mortgage rate than a primary residence
- Utilities (Don’t forget high-speed internet!)
- Maintenance
- HOA dues
- Taxes
- Improvements to the property
- Increased homeowners’ insurance
- Security
- Furnishing the home
- Toys (boat, side-by-side, golf cart, etc.)
- Travel to/from the property
- Cleaning fees
While stretching the budget to purchase the property might make sense in some circumstances, other buyers may be happier with a lower mortgage payment that leaves room in the budget for extra costs like housekeeping and yard maintenance that allow them to spend time at the vacation home being on vacation, instead of working on the vacation home.
Additionally, buyers of a second home will want to carry a higher emergency fund after their purchase.
Not only will the bank want to see a higher cash reserve from a financing perspective, but buyers will undoubtedly find themselves with a higher rate of “unexpected” expenses as the owner of an additional property.
The tax man
As with any large financial transaction, taxes will need to be a primary consideration for your client.
If your client is on the selling end, likely their biggest concern is going to be gathering their costs basis to determine their long or short-term capital gain on the sale.
This is a much more straightforward calculation as compared to a rental property that has added complexities such as Section 1250 depreciation recapture.
One stark disadvantage of selling a second home, as opposed to a primary residence, is that there is no capital gain exclusion on a second home sale (currently $250k for single and $500k for married filing jointly), making tax planning an even more important consideration.
One strategy that could be utilized to circumnavigate this disadvantage is physically moving into the vacation home for two years to satisfy the primary residence requirement and unlock the capital gain exclusion. Be sure to talk to your tax advisor about the details of this strategy.
On the buying end, cash is king and comes with the least tax implications.
Tax planning comes into play when other assets are being liquated to raise the cash for the purchase.
With no 1031 exchange available for a vacation home, your client will want to be prepared for the tax implications of selling other properties, investments, or using retirement accounts to fund their dream vacation home.
In many instances, strategies such as spreading asset sales out over multiple tax years can significantly help your client manage their tax bill.
Sound tax advice is critical for a happy client’s expectations during the purchase and sale of a property, and having a knowledge base that identifies situations to consult their tax advisor is worth its weight in gold.
Estate planning
If you think people can get sentimental about their primary residence, vacation homes can take it to a whole other level.
And this is where estate planning can get tricky.
Do they want to keep the home in the family after they pass? If so, how many kids do they have? Do those kids live close enough to the property that they would actually use it? What if some want to keep it and others don’t? Do they have enough income to cover the expenses to maintain the property? How are those expenses going to get split between the beneficiaries?
You see, it can get very messy, very quickly.
Additionally, if the vacation home is located within a different state from their primary residence, they will likely want to speak with an estate planning attorney to ensure that the asset is properly accounted for within their estate plan. In many cases, it might make sense to utilize an entity such as a trust or LLC to achieve their estate planning goals.
The bottom line is this, vacation homes regularly account for a significant percentage of an estate and your client needs to make a plan for how the property will be handled after their passing with an estate planning attorney.
Financing considerations
If you have a rule of thumb to abstain from showing homes until your client has met with a competent lender and gotten pre-approved, now is the time to stand your ground on that rule.
Vacation home financing comes with a whole unique set of rules that your client may not realize if they are leaning on their prior experiences of purchasing a primary residence.
Cliff Taylor, sales manager at Penrith Home Loans, explains that interest rates have been a difficult topic lately with inflation continuing to cause them to increase. “The primary residence interest rate has moved into the 7 percent range, and a second home or vacation property will carry a rate to higher levels. And that’s assuming it’s a single-family home. Condo interest rates are even higher.”
Taylor also recommends verifying several other factors with the lender that can differ from primary mortgage requirements. These include:
- Down payment requirements
- Debt-to-income ratio
- Credit score
- Location of the property
- Type of property
- Reserve requirements
Given the added complexities of financing a vacation home, be sure to set your client up for success by ensuring that they fully grasp where they stand on financing their dream vacation home.
Beware leased land
It’s not a secret, finding the perfect vacation home isn’t cheap.
And while the reduced cost of purchasing a vacation home on leased land can be appealing, your clients must fully understand the impact of the purchase.
Along with all the expenses above (except for property taxes on the land), a lake cabin, for example, purchased on leased land from the state can come with some tricky decision-making down the road.
An easy case study for this scenario is happening now in Priest Lake, Idaho, where many of the lake cabins which are now valued at more than $1 million are sitting on land owned by the state of Idaho.
As leases expire, the homeowners are stuck with having to attempt to purchase the land their home sits on at auction, often bidding against other interested buyers.
A gut-wrenching place to be, to say the least.
At a minimum, a client purchasing their vacation home on leased land needs to have a financial plan in place that allows them the flexibility to do what is needed when the lease expires.
Short-term rental options
With the continued rise of short-term rental apps, a concept we see coming up more often is utilizing a vacation home as a short-term rental property to offset some of the cost.
This is a completely legitimate strategy, as long as your client is on board for everything that comes with it.
While sharing your property with strangers may be unappealing for some, this could be the perfect fit to get your client into the property of their dreams.
Short-term rentals of vacation homes can also come with a handful of tax benefits your client will want to be aware of.
The most common rule I hear referenced in this regard is the “Augusta Rule”, which was named after the city where the Master’s golf tournament takes place each year and centers around vacation properties rented out for less than 14 days each calendar year.
Regardless of the tax strategy, your client is looking to leverage, we always recommend they are partnered with a good CPA to ensure they dot their i’s and cross their t’s from a tax perspective.
Ultimately, buying or selling a family vacation home will likely be one of the biggest financial decisions in your client’s life and could very well be one of the best life decisions they make for their family.
And while the final decision always lies with them, having a team of financial experts around them to help set expectations and avoid unforeseen pitfalls will leave your client glowing with your service.
Jordan Curnutt, CFP, is a Certified Financial Planner professional for top-producing real estate professionals who want to strategically manage their wealth, optimize variable income, build a balanced net worth, and mitigate what is likely their biggest personal expense, taxes. Reach out to Jordan on Facebook, Instagram and LinkedIn.
