Spring 2008 :: Finance
If you already own a house, you probably have a pretty good idea about the rights, responsibilities and financial obligations of homeownership. And if your experience as a homeowner has been a generally positive one, you might have toyed with the idea of buying a second piece of property.
Why should you consider purchasing a second home? Four reasons spring to mind: finances, fun, family and the future. A rental property can boost your finances, providing you cash flow each month. A vacation home can be loads of fun, serving as a nice getaway spot for you and your loved ones. Many people buy property for family members too, including investment buildings that they rent out and sell later when their children come of age. Lastly, you can buy a second home for your golden years, locking in your future retirement home at today’s prices.
And there’s one other reason to purchase a second home sooner rather than later: With the real estate market slumping nationwide, right now you can get a real bargain.
Of course, buying a house is a huge financial commitment, and it that shouldn’t be taken lightly. So here are some points to keep in mind if you do decide that a beautiful beachfront residence or [taking out “even,” since certain cozy setups might cost more than beachfront homes…maybe]a cozy cabin in the woods is in your future.
Location, Location, Location
We’ve all heard the real estate maxim that location is everything. Well, it’s especially important when it comes to your second home. Nobody buys property with the expectation that it will decline in value. Unfortunately, however, that’s just what can happen if you’re not selective about where you purchase. To increase the odds of your property’s having great resale value, stick to popular areas near beaches, lakes or mountains.
Another important location tip: Think globally. Who says you have to be bound to the U.S., especially when exotic and low-priced areas of the world beckon? Some of the world’s most affordable housing markets are in Canada, the Caribbean and Central America, according to Coldwell Banker’s 2007 Home Price Comparison Index Survey. The survey analyzed 77 markets outside the U.S., and came up with the average sales prices of single-family four-bedroom homes with approximately 2,200 square feet of space. The results: Mexico, for example, offers terrific bargains, with average sales prices ranging from $246,522 in Guadalajara to $277,213 in Mexico City. That presents a particularly attractive option for those who might otherwise spend a small fortune in sunny U.S. destinations like Florida or California. Also topping the list of locales with affordable real estate around the world are cities in Bahrain, China, Colombia, Egypt, Malta and Poland. Some of these places may be of particular interest to you if your family tree has roots abroad.
It’s a Pity
Of course, cost is a major consideration when contemplating a second home. Mortgage interest rates are still at relatively low levels—on the order of 7 percent or so. However, interest rates on second homes typically run about half a percentage to a full percentage point above rates for your principal residence. Insurance costs can be higher too, particularly if you buy a vacation property in a hurricane-prone locale, such as Florida.
The most important cost consideration is one most people probably never think about. It’s the overall true cost of owning and maintaining a second home. Don’t make the mistake of underestimating the real cost of home ownership for a vacation property or even a piece of rental real estate. Common wisdom tells you to think about PITI—Principal, Interest, Taxes and Insurance—before you buy. With a second home, however, you’ll need to think well beyond those parameters. You’ll also have to pay for some, or all, of the following:
- Advertising for renters
- Appliances
- Carpets, flooring and rugs
- Chimney servicing
- Fees (to a landlord or professional property manager)
- Furniture
- Gardening supplies
- Home improvements (additions, renovations and upgrades)
- Lawn care
- Lighting fixtures
- Maintenance
- Moving costs
- Repairs
- Supplemental insurance (earthquake, flood, hurricane or tornado coverage)
- Utilities
- Window treatments
This list of hidden expenses all contribute to the true cost of homeownership. You’d be wise to set aside money in a home expense fund each year. Stash away at least 2 percent of your home’s value in order to pay for the items above without going into debt.
Don’t Forget the Tax Man
When you rent out a second home, you’ll have to adhere to strict IRS rules in order to reap the biggest possible tax benefits from your real estate investment. Tax laws concerning second homes are complicated, so you’ll definitely want some professional advice. However, you don’t need an accountant to teach you the basics.
First off, there’s the capital gains exemption. With your primary residence, you are allowed to exclude up to $250,000 in capital gains when you sell your house. The exemption is even larger—$500,000—if you are married. Unfortunately, that exemption doesn’t apply when you sell a vacation home. To receive the tax break, you’d have to make that vacation property your primary residence for at least two years.
Then there’s what I call the “14-day rule.” This refers to the number of days that you rent out a second home—if it’s 14 days or less over the course of the year, you don’t have to report the rental income to the government. This means you don’t pay taxes on that income. The downside, though, is that you can’t write off any expenses you might incur for renting out your property.
If you rent out a second home for more than 14 days, you are legally permitted to deduct expenses. Your deduction, however, is limited if your personal use of the home adds up to more than 14 days a year, or more than10 percent of the total rental days. The limitation prevents you from deducting expenses that would create a loss. So let’s say you earned $10,000 in rental income, but your expenses totaled $15,000. You can only deduct $10,000 in expenses; the other $5,000 worth of expenses are not tax deductible.
But if you use your second home for 14 days or less or for less than 10 percent of your total rental days, then it is considered a rental property, entitling you to deduct up to $25,000 a year in net losses. The deductions for so-called “passive losses” start to phase out when your adjusted gross income hits $100,000 and disappear completely at $150,000.
As you can see, the rules can get complex, so be sure to enlist the services of an accountant to minimize your tax burdens—and stay on the right side of the law. Armed with this information, you can enjoy the personal and financial benefits of owning a second home.
Lynnette Khalfani-Cox, the Money Coach, is a personal finance expert, speaker and author. Her latest book is Your First Home: The Smart Way to Get It and Keep It. To sign up for Lynnette’s free personal finance newsletter visit her Web site, themoneycoach.net.
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