A vacation home is a secondary dwelling, other than the owner's principal residence, and is used primarily for recreational purposes including vacations or holidays. Also known as a recreational or secondary property or residence, a vacation home is often situated in a different location from the owner's primary residence. Because vacation homes are only used at certain times of year, many owners rent out these dwellings when they are not using them.
Property is divided into several different categories, usually for income tax purposes. The property that a homeowner lives in is referred to as their principal or primary residence. This property can be a home, apartment, condominium, or trailer. In order to qualify as a principal residence, the homeowner—whether that's a single individual, a couple, or a family—must live there for the majority of the year.
A vacation home, on the other hand, is much different. This type of property is often considered to be a second home. In most cases, it's in a different location than the owner's primary, principal residence. As noted above, the owner may use this property for recreational purposes including vacations, usually for a few days or weeks each year. Just like primary residences, vacation homes can take any form—the most popular being cottages or condos.
The distinction between primary residence and vacation property may be a blurred line to individuals, especially if they spend a considerable amount of time in both locations. However, the distinction is important for several financial matters.
Renting Vacation Property
Aside from providing the homeowner with a place to get away, vacation properties can also be rented out to produce additional income when they're not being used. In this case, a couple with a principal residence in Maine may own a vacation home in Florida. The couple may visit the Florida residence during Maine's coldest months while renting it out to other people for the rest of the year.
Although they're a great asset to have, vacation homes may be a financial challenge. For instance, a mortgage on a vacation home may have a higher interest rate than a loan on a homeowner's primary residence. That's because the owner may have a higher risk of default as individuals are more apt to save their primary residence than a temporary one in the event of a reversal of fortune. Owners of vacation property may also be taking on a second mortgage if the mortgage of the primary property has yet to be paid off yet.
This form of investment is also risky when considering the potential for rental income. Renting out a vacation property does not provide stable or consistent cashflow; even if the property is in a desirable location, most vacation property renters will service shorter-term customers compared to tenants or long-term residents. Therefore, landlords of vacation property must prepare for potential cashflow shortfalls and be available to step in and pay for expenses not covered by rental income.
Tax Implications of Renting Vacation Property
In order for a vacation home to be classified as a residence by the IRS, it must offer basic living accommodations including sleeping space as well as cooking and bathroom facilities. The home must also be used for personal purposes for more than 14 days and 10% of the total number of days the home is rented at a fair rental value.
It is also increasingly popular to rent out vacation homes on a short-term basis through services like Airbnb or Vrbo.
The vacation home tax rules for a residence will apply if those requirements are met. Deductible expenses would include the rental portion of qualified home mortgage interest, real estate taxes, and casualty losses. Other expenses that can be deducted stem directly from the rental property and include advertising, payment of commissions, legal fees, and office supplies. Expenses related to the maintenance and operation of the rental property are also deductible.
If a vacation home is rented out for 15 days or more per year, the rental income must be reported to the Internal Revenue Service (IRS) using Schedule E.
Owners can also deduct any expenses associated with that residence. If the home is considered a personal residence, the deducted expenses cannot exceed the rental income. If the vacation home is not a personal residence, the deducted expenses can exceed this threshold, but the reported loss may be limited by passive-activity regulations.
Financial Implications of Owning a Vacation Home
Owning a vacation home may be financially similar as owning a primary residence. In that light, there are many financial aspects of owning a vacation home, meaning the owner must consider more than just the purchase price of the piece of real estate they buy. Below are the most common operating costs a vacation home owner can expect to incur.
Mortgage Payments/Interest: If you took out a mortgage to purchase your vacation home, you'll need to make regular mortgage payments. In addition to paying off the principal balance of your loan, you'll incur interest expense that is heavier at the beginning of your loan when the principal balance of your mortgage is highest.
Property Taxes: Depending on the location and value of your property, you may pay thousands of dollars in property taxes each year. Property taxes are sometimes billed twice per year, though some property owners may be required to pay property taxes into an escrow account overseen by the mortgage lender to ensure prompt and timely remittance of property tax assessments.
Repairs/Maintenance: Maintaining a vacation home can be expensive. You'll need to budget for things like cleaning, landscaping, repairs, and upgrades. You can decide to perform all of these activities on your own or may contract these services to others (often at a higher cost).
Consumables: Though not a direct home cost, you'll also need to consider the cost of replenishing consumables each time you visit your vacation home; for example, you may have to refill the refrigerator if your stays are few and far between.
Insurance: You'll need to insure your vacation home in order to protect it from damage or theft. Your lender may require a certain level of coverage, and your insurance cost is often directly correlated to the value, location, and various risks of your property.
In addition to the ongoing expenses above, vacation home owners must consider how real estate properties may fluctuate in value. The market price of a property may increase or decrease based on prevailing macroeconomic conditions such as monetary policy, interest rates, or industry supply.
Selling Vacation Property
When the owner of a vacation home sells the property, they should consider implications on capital gains. In most cases, these capital gains must be reported to the IRS. That's because vacation homes are treated as personal capital assets. Owners are taxed on the profits of the sale, which are reported on Schedule D, for the year the property was sold. This form accompanies the owner's annual tax return.
The important distinction here is that this rule only pertains to vacation property, as taxpayers have a substantial tax benefit when selling a primary residence. When selling a primary residence, the taxpayer is exempt from the first $250,000 for single filers or $500,000 for couples filing jointly.
Challenges of Owning Vacation Home
Many aspects of owning a vacation home are appealing; after all, imagine escaping terrible weather or busy lifestyles on a whim to a second location you own. However, there are ongoing challenges on owning a vacation home that create financial and non-financial hurdles.
One of the primary logistical challenges of owning a vacation home is maintenance and upkeep. Vacation homes require regular maintenance and upkeep, even when you're not there. This can be especially challenging if your vacation home is located far away from your primary residence, making it difficult to handle any unexpected issues that may arise.
On a similar note, depending on the location of your vacation home, you may need to worry about issues such as hurricanes, flooding, or wildfires. These natural disasters can be expensive to deal with and can cause significant damage to your property. Your vacation property may also require emergency prevention actions (i.e. boarding up windows) on a short notice, something that may not be possible based on where your primary residence is located.
There are several emotional aspects to overcome when considering a vacation home. Depending on your lifestyle and schedule, you may not be able to use your vacation home as much as you would like. This can be frustrating, especially if you have decided to invest a substantial amount of money in the property. The opposite end of the spectrum occurs when its time to part ways with a vacation home. Similar to other forms of investments with sentimental value, it may be challenging to part ways with something you already own even if it makes the most financial sense for you and your legacy. Also, like other forms of investing, there are many elements of trading psychology.
Last, as discussed in sections above, there are several unique financial challenges of owning a vacation home. Rental income may not be stable, and relying on a third-party to rent your property will incur material management fees. You'll also incur potentially higher costs to operate your property if you don't plan on always being on site. For this reason, those considering a vacation home as an investment would do well to consider the true long-term financial implications of their purchase.
Vacation Home vs. Investment Property
Some vacation homes may be considered investment properties, but not all investment properties are vacation homes. As mentioned above, the owner of a vacation home may use it to produce extra rental income, making it an investment property when they're not using it.
In other cases, someone who buys an investment property may do so for the sole purpose of generating income either through rent or the future resale of the property. Unlike vacation properties, investment properties don't need to be homes. They can be residential as well as commercial properties, or even mixed-use structures—properties with both residential and retail spaces. These investors may never actually step foot inside of the property; however, they may still be able to generate a similar income stream compared to someone who owns and personally uses a similar type of asset.
Vacation Property vs. Timeshare
Vacation property and a timeshare are technically the same thing, However, not all forms of vacation property may have the same ownership structure as a timeshare.
Broadly speaking, most vacation homes are property that you own outright and can use whenever you want. You have full control over the property, and can use it as a second home or rent it out to generate income. You're also responsible for all the expenses discussed above that come along with owning and maintaining the property.
A timeshare, on the other hand, is a type of vacation ownership that allows you to use a property for a specific period of time each year. Timeshares are usually sold in increments of one week. For this reason, the cost of owning this form of a vacation home is much cheaper than 100% outright ownership of a vacation home. However, the investor in a timeshare may only reside in the vacation home for the period of time corresponding to their ownership.
Because of the limited time period an investor can reside in a timeshare, all timeshares are often considered vacation property. However, because different forms of vacation properties may be accompanied by shorter or longer periods of stay, not all vacation periods have the same restrictions as a timeshare.