Home ownership has long been part of the American dream. And second home ownership – whether as an investment, a getaway or both – is the cherry on top of that dream.
Second home ownership has surged in recent years because of the pandemic, remote-work opportunities and a growing population of retirees with time and lifelong savings to enjoy. After all, snowbirds need southern nests.
Estimates vary, but industry studies indicate that about 5% of American adults – one in 20 – own a second home.
These figures include “escape” homes that are used strictly as leisure getaways, investment properties that are rented out and homes that are a combination of both – used as personal escapes on a limited basis, and rented out the rest of the year. It might be legally limited, or they might limit themselves for any number of reasons. For instance, they might not have time to be there more often,or only interested in ski season.
If you’re considering purchasing a second home, now or in the future, you should do some research and have a plan. This applies even if you’re one of those rare lucky people who plans to buy a second home but does not contemplate ever selling it. You can save yourself, and your heirs, from being blindsided by costs before, during and after the purchasing process.
To help you navigate this often long and complicated process, Escape Home contributor Timothy Harper looked at dozens of publications for advice from bankers, mortgage lenders, real estate agents, lawyers, financial advisors, tax preparers and experienced purchasers.
Misconceptions about buying a second home
First, let’s dispel a few common misconceptions. A second home is, above all, a home. It can cost as much to buy and maintain as your primary residence. If it is a rental property, don’t think of it as a “passive investment.” It’s not like a bond you buy and forget for 10 years. You’ll be running a small business. You’ll be thinking about it every day. And the work you put in may make your second home seem like an aggressive rather than a passive investment.
Too many people go on vacation or visit friends’ second homes and fall in love with the area. They set their hearts on a community or a specific property, and then try to make the money work. Beware of that. It’s fine to look casually at a few properties to get an idea of the available housing in any market, but go to your banker or mortgage lender before getting serious about the search. Find out what you can afford before allowing yourself to set your heart on any particular cabin or cottage or condo.
Speak to your financial advisor as well. Advisors often want their clients to tick off certain financial boxes before looking for a second home, including:
- Saving at least 15% of their income for retirement;
- At least six months of living expenses saved as a fallback;
- Zero credit-card debt;
- A well-padded college fund for their kids.
Some even urge their clients to consider second homes only after they have fully paid off their mortgages on their primary residences.
Financing can be a challenge, especially when mortgage interest rates are rising. Second homes are often more expensive to finance, especially second homes that are used exclusively as rental properties. If it’s an investment property, banks treat it as a business, and set more stringent lending requirements, including higher credit scores, higher interest rates and higher monthly payments.
Debt-to-income (DTI) requirements – the percentage of your monthly debts taken out of your pre-tax earnings – of 40-43% are not unusual for second home mortgage applicants at some lending institutions.
For a second home that’s going to be a rental, a lender may want market-based assurances from real estate professionals about your monthly rental income and expenses. As with any business, lenders want to see reliable income forecasts in order to feel confident that your rental will work and you won’t go broke and walk away.
Lenders may also require accurate estimates for your closing, renovations, taxes, utilities, maintenance, security, cleaning, rental management and other regular monthly and annual costs. Does the community require registration licensing or fees for rentals? Is there a required homeowners association (HOA) fee?
The intricacies of mortgages for investment properties are a big reason many buyers resort to home equity loans (HELOC) taken against the value of their principal residences, or loans offered through many large financial services companies against the holdings in retirement accounts. Those options mean fewer hoops to jump through since you are in effect loaning yourself the money for the second-home purchase, instead of borrowing it from an institutional lender.
Other costs to consider
Beyond the considerations associated with financing, you’ll want to keep in mind personal costs that the bank won’t ask about but will definitely be a factor, such as the cost of commuting to the getaway: gas, tolls, and train or plane tickets all add to your overall costs. What about the wear and tear on your vehicle(s)? Are you going to need a second car? A station car?
Ask your tax professional about any potential write-offs if part of your second home is used as an office or workshop for your business. There may be some tax write-offs available, including the costs of traveling to and from the remote home office.
In addition, be aware that when you buy a second home, the government takes away some of the financial advantages of purchasing a primary residence. For example, the IRS tax deductions for mortgage interest do not apply to mortgages on investment properties.
You must report your rental income on your tax returns, and the IRS treats it as ordinary income.
On the other hand, an investment (rental) property can afford opportunities for deductions that aren’t available for primary residences. You typically can’t deduct your payments to your lawn crew or tree service or cleaner at your primary residence, but you may well be able to take those payments as business write-offs on an investment property.
Deductions and revenue rules
The IRS has strict rules on second homes that are also rented out:
If you rent a dwelling unit to others that you also use as a residence, limitations may apply to the rental expenses you can deduct. You’re considered to use a dwelling unit as a residence if you use it for personal purposes during the tax year for a number of days that’s more than the greater of:
- 14 days, or
- 10% of the total days you rent it to others at a fair rental price.
Don’t try to fool the government or your bank. If you’re hoping to rent out more than allowed for a personal second home, say so from the beginning. Be transparent, or risk committing fraud and getting in real hot water, including tax penalties and even criminal fraud charges.
The status can change- second home or investment property- from year to year, as far as the IRS is concerned. A house can be a rental one year, treated as a business, and a personal escape home the next year. Just make sure you tell your tax professional all about it.
So it’s a big question from the very beginning: how are you going to use the second home? What are you expecting in terms of investment return? And how are you going to achieve those returns?
It may seem daunting, but take it from someone who has had three second homes over the years, variously as personal escapes and rentals. There are never guarantees, and there are always unforeseen problems with any form of home ownership, but with some planning and precautions taken in the early stages, you can increase the chances of your second-home investment paying off for you.