Vacation homes can be a great place to unwind, enjoy leisure time, and create lasting family memories. They can even serve as a secondary source of income if you rent them out when not in use. But after adding up all these considerations, are they really a good investment?

If you’re thinking about buying a vacation home, it’s important to recognize and understand the emotional factors that influence your decision and balance them with practical considerations. Here are some tips to help you get started. 

6 Considerations to Determine if Your Vacation Home Is a Good Investment Property

While difficult to quantify, try to assess how much enjoyment you'll get from using the property for your own wants and needs, like vacations, relaxation, etc. However, if you view it as more of an investment opportunity, then the following list of considerations can help you evaluate whether or not it makes sense as an investment property:

1. Location

• Is it in a desirable location with amenities, attractions, and a strong tourism industry?
• What is the proximity to beaches, ski resorts, parks, and golf courses or other alluring attractions?
• Can the location add to the potential appreciation of the property’s value?

2. Market

• Analyze historical data, including property values, price appreciation rates, and market stability.
• Is the local market growing, stable, or declining for long-term investment?

3. Expenses

• Have you identified and calculated property taxes, insurance, maintenance and repairs, HOA fees (if applicable), property management fees (if applicable), and utilities?
• Does the total price fit your budget?

4. Financing

• How are you planning to pay for the vacation home?
• What are your available financing options if you do not have enough cash?
• What are the mortgage rates, loan terms, and down payment requirements?
• How would the financing costs impact your investment’s profitability and ability to generate positive cash flow?

5. Rental

• What is the rental potential of the vacation home?
• What is the occupancy rate, and how much can you charge for rent?
• Can the rental income cover all the potential expenses on the vacation home to generate your decided profit?

6. Risk

• Have you assessed the risk associated with owning a vacation home?
• Do you have a contingent/emergency fund to mitigate unforeseen events like rental damage, unexpected vacancies, and real estate fluctuations?
• Can your budget handle these risks and ensure your investment aligns with your risk tolerance?

Understand the Tax Implications of Buying a Vacation Home

Tax implications can vary depending on multiple factors, including the location and purpose of the vacation home, and they can impact the overall pricing. Make sure you also keep these five tax considerations in mind as you look for the perfect vacation home.

1. Understand Your Location-Based Taxes

Familiarize yourself with vacation home ownership's tax rules and implications. Dig into your local property taxes, rental income taxes, and any deductions or exemptions available. Also, different countries, jurisdictions, and regions may have location-specific tax laws regarding vacation home ownership, including property and capital gains taxes. Some states even have an “Exit Tax” where you pay either a percent of the profit of your sale, or as much as two percent of the sale price if you sell and do not use the proceeds to purchase again within the state. In many cases, working with your financial advisor or experienced tax professional can help you optimize your tax situation and identify a game plan before you buy a vacation home.

2. Identify the Deductible Expenses

When you buy a vacation home, you may be eligible for certain deductions associated with owning and maintaining a vacation home. These include mortgage interest, property taxes, insurance premiums, and operating costs. Experienced financial advisors and tax professionals can help you identify and reap the benefits of these tax deductions.

3. Clarify the Intention of Use

Suppose you intend to purchase a vacation home from an investment perspective and rent it out. In that case, the tax implications or deductions may vary based on the days you use the property. A residence rented less than 15 days in a taxable year may not have to report rental income. If you do not rent out the home, you may be able to claim the home as a qualified second home and take the deduction. Stay in touch with professional tax professionals to understand the rules around personal use versus rental use and how they impact your tax situation. If you do decide to rent out (partially or wholly for the greater of 15 or more days per year), you must report any rental income from your vacation home on your tax return, including income from short-term rentals or long-term leases.

4. Deciding on Rental Property Entity

Depending on your circumstances, holding the vacation home in a separate legal entity such as an LLC (Limited Liability Company) or a corporation may be beneficial. This can provide liability protection and potentially offer some tax advantages. Your financial advisor can help you determine the most appropriate structure based on your situation, tax implications and eligible deductions. Regarding protections, having proper homeowner’s coverage based on vacation usage or rental usage is important as well as reviewing the need for Umbrella Insurance coverage if appropriate. 

5. Determine if You Are Eligible for a 1031 Exchange

The benefits of the 1031 exchange are applicable only if you use your vacation home as an investment property. In this case, if you sell a vacation home and reinvest the proceeds in another qualifying investment property within specific timeframes and guidelines, you may be able to defer capital gains taxes through a 1031 exchange. These deadlines include but are not limited to identifying the next qualifying property within 45 days and acquiring it within 180 days. Working with a tax professional or financial advisor familiar with these rules and pitfalls can eliminate costly mistakes in attempting this strategy.

Maximize Vacation Home Investments with a Team of Professional Advisors

Buying a vacation home can be a dream come true, but the need for due diligence is equally important. With guided and informed decision-making, your vacation home purchase can undoubtedly yield better and more sustainable investment returns—alongside its personal benefits as a vacation spot for you and your family.

At Wealth Enhancement, we use a team-based approach called the Roundtable™ to offer customized, comprehensive financial and wealth management solutions, including estate planning and insurance. To learn more about how we can create a unique plan for you and your new vacation home, reach out for a free, no-obligation meeting.