by: Stephen M. Pollan
and Mark Levine
Illustrations by: Gary Hovland
After renting on Martha's Vineyard for eight
summers, Janet and Mitchell Peters (not their real names) decided
to
buy a vacation home there. A $100,000 inheritance would serve
as their down payment, and renting out the four-bedroom house for
part of the season would help defray the mortgage and maintenance
costs. "I even had dreams of coming out ahead on the deal," says
Mitchell. But when they met with their accountant, the Peterses
discovered that making the house pay for itself wouldn't be easy. In
order to avoid owing stiff income taxes on the rent they collected,
for example, they'd have to severely limit their own use of the
house. "We'd wind up spending less time on the Vineyard than if we
were still renting," he says.
Millions of Americans daydream about buying a
second home in a coastal paradise, a favorite ski area, or a
peaceful country town. A secondary residence can offer a weekend
getaway, a place for extended families to gather for vacations, or
one in which to retire in the future. It can also be a good
investment, since well-located real estate typically appreciates in
value. And then there's the truly tantalizing thought that renting
out the house will let it pay for itself, at least partially. But
buying a vacation home involves some tricky financial planning:
Everything from mortgages to homeowner's insurance will cost more
than
it does for a primary residence. And though you can write
off mortgage interest and property taxes, renting out the property
complicates your income tax picture. So here are some important
considerations to bear in mind as you scan the real estate
section.
BORROWING: MORE
EXPENSIVE
Banks talk a good game about the typical
second-home buyer being the kind of customer they're after: someone
who's affluent and willing to use credit. But when push comes to
shove, it's just that—talk. The loan terms they offer aren't as good
as those for primary residences.
"Second-home buyers typically face
mortgage rates at least one-quarter to one-half a percentage point
higher than if they were borrowing to buy a primary home,"
says
Julie Teitel, a mortgage broker with IPI Financial Skyscraper, in
New York City. "They'll also face the demand for more points up
front."
Teitel says that's because second-home buyers
are by definition stretched thinner financially, and the accepted
lending wisdom is that a borrower would rather fall behind or
default on the mortgage for a vacation or weekend home than for a
primary residence.
"Second-home buyers shouldn't count on using
potential rental income as a way to entice lenders," warns Teitel.
"Some banks won't make loans on income property at all." Those
lenders who will consider them—typically smaller banks located in
vacation areas—will want cash-flow statements and extensive
appraisals, and even then won't take more than 75 percent of the
rental income into account, Teitel says. Of course, if your original
intent when you obtain the loan is to use the home as a residence
but you subsequently change your mind and decide to use it as an
income property, no bank will cry foul as long as the payments are
made.
Despite the downsides, Teitel believes it
still makes sense to look for a separate mortgage rather than using
a second mortgage on your primary residence to finance a vacation
home. "Even though the home equity loan might be simpler to obtain,"
she says, the rates will probably be higher than on a separate
vacation-home mortgage. In addition, you can deduct up to $1.1
million in interest on two mortgages combined, but only up to
$100,000 on home equity loan interest.
INSURANCE
PITFALLS
Insurance on a second home typically costs
15 to 20 percent more than on a primary home, simply because you're
not there as often to keep an eye on things, says Andrew Schutzman,
an insurance consultant with AMS Risk Management in Rockville
Centre, New York. And if you're going to be renting the house,
coverage could cost more still (at least another 20 percent), since
most insurers consider a tenant's stay to be more likely to result
in property damage than an owner's, he says.
You can keep these surcharges to a minimum by
installing
a monitored alarm, buying in a gated community,
showing there's a natural water source near a rural property (so the
fire department can douse a blaze), or getting a package policy with
the insurer who covers your primary home and cars.
Add some umbrella liability coverage to your
homeowner's coverage as well. Not only does owning a second home
mean you have more assets to protect, but if you plan on renting,
your exposure to lawsuits for accidents or injuries that occur on
the property increases dramatically, says Schutzman.
THE TAX
PUZZLE
"The way the I.R.S. treats your second
home, and the tax options available to you, depends on how often you
rent
it and how often you use it yourself," explains Richard
Koenigsberg, CPA, of Spielman, Koenigsberg & Parker, in New York
City. The I.R.S. characterizes your second home in one of three
ways: rental property, mixed-use property, or personal
residence.
RENTAL PROPERTY- This category offers the best tax advantages, but
limits how much you can use the house. For your second home to be
considered a rental property you must rent it (at market rates) for
at least 15 days a year while using it yourself for less than 15
days, or 10 percent of the number of days it's rented, whichever is
greater. For example, if the Peterses rented their cottage on
Martha's Vineyard for six months (180 days), they (and their family
and friends) must use it for less than 18 days for it to be
considered a rental property.
Why bother trying to qualify for rental
status? "Because you can then deduct all the costs associated with
operating, repairing, and maintaining the property from any rental
income," explains Koenigsberg. So in addition
to deducting the
mortgage interest and real estate taxes, you can claim utilities,
lawn care, repairs, insurance, cable television, garbage removal,
and all your other expenses. "You could even claim the cost of
traveling to and from the property," Koenigsberg notes. The purchase
price of appliances and the house itself can be depreciated, or
gradually written off, over 7 years and 271Ú2 years
respectively.
Still, the total amount of rental expenses you
can write
off in any one year is limited by the I.R.S. If you
meet the personal use requirements, and your adjusted gross income
(AGI), for joint or single filers, is less than $100,000, you can
deduct up to $25,000 a year in excess of rental income. Have an AGI
of between $100,000 and $150,000, and that $25,000 "landlord
allowance" is reduced; and if your AGI tops $150,000, your
deductible expenses cannot exceed your rental income. "Since most
second-home owners have high taxable incomes, owning
a rental
property becomes, at best, a wash: The expenses offset the income,"
says Koenigsberg. "You end up with a lovely place to stay for a
short time in exchange for lots
of bookkeeping, the expense of
hiring a rental broker,
and a higher tax preparation bill from
someone like me."
MIXED
USE
"If you use the property more than 15 days or
10 percent of the time it's rented, your house falls into the
mixed-use category and the tax benefits drop considerably," explains
New York City-based real estate attorney Mitchell Stern. From a tax
perspective, that makes things complicated.
Deductions on a mixed-use property are
apportioned based on the amount of time the house is rented. "If
tenants rented the home for 25 percent of the year, you can only
write off a percentage of each rent-associated expense that matches
the percentage of time the house was rented," says Stern. If, for
instance, you spent $1,000 a year on lawn care on a property that
was rented 25 percent of the year, you can only deduct $250.
Meanwhile, mortgage interest and taxes can be written off against
the rental income, although you can only claim 25 percent on your
Schedule E (rental property tax form), and the rest gets written off
on your Schedule A (itemized deductions). "The catch is, you can't
deduct any more in total expenses than it takes to offset the rental
income," Stern adds. (Rental expenses you aren't able to claim can
be
carried forward to offset next year's rental income,
if
need be.)
PERSONAL
RESIDENCE
If you rent your second home for less than 15
days a year, or don't rent it at all, it's considered strictly a
personal residence by the I.R.S. That means you simply deduct the
mortgage interest and real estate taxes on your Schedule A. But
there's an intriguing loophole: If you rent out your vacation home
(or your primary home for that matter) for 14 days or less, the
I.R.S. ignores the income. Yes, you read that right. "Not only don't
you have to pay taxes on that money, but you don't even need to
report it," says Koenigsberg. "The tenant isn't required to report
the amount or length of any stay either," he adds. (The I.R.S.
relies on homeowners themselves to report rental stays—no matter how
long.) The amount you earn in those 14 days is irrelevant. Whether
you bring in $200 for renting your house during graduation week at
State U or $20,000 renting your house in Augusta during the Masters
doesn't matter; it's all tax-free if the term is less than 15
days.
The message is clear: If you want a second
home to be
a tax-free moneymaker, buy in a location where you
can make a lot of money renting for a very short period of time. In
other words, second-home investments shouldn't be analyzed on the
basis of money alone. Despite the added (and often unexpected) costs
involved, vacation-home owners tend to find that the benefits
outweigh the burdens. For the Peterses, buying and renting out their
Vineyard house has meant a lot of headaches, Janet admits. "Still,
we'd do it all over again. It has brought a lot of joy to our
lives."
