Question: We are buying a vacation home this winter and wondering how the process and rules differ from our experiences buying our primary residence.
Answer: Buying a vacation home is a little like buying a primary home, but there are key differences you should be aware of. Lenders tend to set more stringent lending requirements and you must be clear about your plans for the property. With these considerations, potential buyers can plan for the financial obligations and time commitments common to the purchase of a second home.
What Counts as a Second Home?
Lenders treat primary residences, second homes or vacation homes and investment properties as unique types of property purchases. Typically, lenders are more likely to grant loans with more favorable terms to people purchasing homes as a primary residence, as the occupation of the home usually ensures a higher degree of timely repayment. Properties that will never be occupied by the owner have different lending and tax obligations. As such, to buy a second home or vacation home, lenders often require you to choose properties that are a set distance away from your primary residence. You must also indicate that you’ll occupy the property for a set amount of time each year.
Vacation Home or Investment Property
Given that a vacation home must be a notable distance from your primary residence, you should consider the type of arrangement that works best for you. Homes suffer from lack of attention, so you should be prepared to make regular visits for maintenance and repairs, or hire a local company to do so. Larger or more remote properties may demand more care, while a condominium in a developed area might require less. You may also choose to rent out the property in your absence to help pay for the mortgage. However, this may affect the classification of the property purchase, and have other tax implications.
Capital Gains Taxes
Selling a primary residence often qualifies the seller to exclude up to $500,000 of the capital gains from their tax liability for a married couple ($250,000 for a single person), but vacation homes are viewed differently. Typically, a homeowner must have lived in the home as a primary residence for at least two of the past five years to qualify for the maximum capital gains tax exclusion.
People who never occupied the home as a primary residence do not qualify for the exclusion and may be required to pay capital gains taxes. Buyers who eventually intend to occupy the vacation home as a primary residence should carefully consider when they plan to sell both properties. For example, a person who sells a primary residence and moves into a vacation home may be able to claim the vacation home as a primary residence, if they occupy it for a minimum amount of time. However, they cannot claim the capital gains tax exclusion more than twice in a two-year period.
Down Payment and Mortgage Interest Rates
People read about down payments as low as 3 percent to buy a home, but these programs are generally aimed at borrowers looking to purchase a primary residence. A vacation home represents a higher degree of risk, since the lender cannot count on the buyer’s full time occupancy to entice adherence to the loan.
As a result, you should plan to make a down payment of at least 20 percent of the second home’s sale price. You may need to pay more to satisfy lender requirements, particularly if your debt-to-income ratio is on the higher side. Due to the increased risks inherent to second properties, lenders may also set higher mortgage interest rates.
Mortgage Interest Deduction
The mortgage interest deduction can be an excellent way to offset some of the costs of purchasing a home and paying a mortgage, but there are limits on this deduction for owners of multiple properties. First, the total mortgages that owners can use in the mortgage interest deduction must be less than $1 million total–possibly somewhere around $500k if the laws change–if they are married filing jointly. Second, owners of more than two properties can only deduct the interest of one primary residence and one second home. Third, people who own a vacation home but rent it out periodically must occupy the home for at least 14 days a year, or 10 percent of the amount of the time the home was rented throughout the year, whichever is greater.
People who convert a vacation home into an investment property may also be able to deduct a portion of the mortgage interest they pay on the home, but the tax guidelines for investment properties are different than owner-occupied homes.
Buying a second home is an investment that turns out to be quite unique from buying a primary residence. Hopefully these tips will help you make a better decision. Most importantly, good luck finding your perfect vacation home!