Please don’t buy a second home
Sometimes when folks read or hear my recommendation for buying a house they think, “If one is good, two should be better, right?” Well, sorry, no. Please buy a primary residence for you and your family (be smart about it) but also please don’t buy a second one. The challenges that Jim Collins outlines for personal residences as an investment are surmountable for your primary home, but are very difficult to overcome for a second. Collins suggests renting is better than buying, but I think with smart choices, as detailed in the previous article, buying is the better choice. But for a vacation home, renting is definitely better than buying. Why?
The first two reasons why you shouldn’t buy a vacation home really ought to unseal the deal: property taxes and maintenance costs. Neither add to your wealth or the value of the property; they merely keep the property in your hands and not declining in value. Property taxes average 1% annually (half that in Wyoming, three times that in New York) and maintenance will average 1% again. That’s 2% of the purchase price just to keep the property in your hands, even if you paid cash (if not, then add financing costs). A median level vacation home sells for $500,000 and 2% of that is $10,000. That’s a lot of vacationing. The people I’ve seen who spend that much are rarely being responsible with their finances, which is sorta the point of this whole exercise.
I can hear your response now: what about renting it out? That’ll cover taxes and maintenance and financing and we’ll make money too, right? Maybe, but realistically, probably not. The reason is one that people rarely consider, and that’s the cost of upgrading and outfitting a vacation home. If you own a home already you know how expensive outfitting a house is: beds, couches, modern appliances, flat screen TVs, driveways, and on and on. At our house we say that everything comes in $1000 increments. New washing machine? Boom, drop a grand. You can easily spend 10% of the purchase price the first year upgrading and furnishing a vacation rental. Have you priced window coverings lately? Ouch. And guess what, ten years later you need to turn around and do it all over again. For many things, it’s sooner than that. Re-upping on tens of thousands of dollars worth of new, non-durable goods every few years eliminates the dream of profitability. Hotels replace their mattresses every four to seven years, to give you a frame of reference.
OK, OK, what if you have an in at IKEA and you’re really good at shopping, and the place you’ve found is simultaneously really inexpensive and has a high rental rate throughout the year . . . could it work? Please Christopher, can it, can it? Well, once you put it like that, maybe. First, let me deflate this bubble a bit. No surprise, popular locales with high rental rates also have high sales prices. Think about special place that you love to go—the houses are expensive because you’re not the only one who feels that way. I love north shore Kauai. Mark Zuckerberg bought a chunk of it in 2014 for $100 million. Great, now it’s out of my price range. It’s possible that you could find a place you love for a reasonable price, either during a down market or from a highly motivated seller, but those situations are rare.
But let’s indulge this fantasy a little. The challenge is to define what it is you’re really looking for. Are you trying to reduce your vacation costs? Do you want to be a real estate investor? Are you thinking you can combine the two and have the best of both worlds? Our friends at the IRS have an opinion on this naturally, and, well, it’s complicated. If the property is primarily for investment than yes it could, possibly, be profitable over time, particularly since you can take advantage of depreciation and expenses to reduce the rental income and possibly some of your other taxable income (like I said, it’s complicated). But over time the depreciation deductions start to disappear, so more rental income needs reporting, and when you go to sell it you don’t receive any beneficial tax treatment to shelter the gain. And while the IRS allows you to stay in an investment property, you can only do so “incidentally,” which is defined as 14 days or 10% of the days it’s rented, whichever is greater. (You could always do a 1031 exchange into another property, but that’s a different story.) There is a small loophole, though: days you spend “maintaining” the property don’t count towards your 14-day exclusion—so if you like to work on vacation, you’re in luck!
If the property is truly a vacation home, you can’t write off depreciation and many of the expenses, though you do get to take full advantage of the mortgage interest deduction, up to $1.1 million in debt secured by personal residences. The IRS does allow you to rent your vacation home for up to 14 days, and you don’t have to report any of that income. Be careful, though, because as soon as you rent it for 15 days in a year ALL the rental income is taxable. Like I said, it’s complicated. It’s conceivable in some locales that 14 days of rental could amount to a decent sum and that would offset some of your costs.
Two other issues I haven’t mentioned yet, but they’re biggies: time for maintenance and loss of options. As mentioned previously, the costs of outfitting and upgrading can be steep. The additional challenge associated with upgrade costs are timing. When is the seven-year old washing machine going to break? Who knows, it could be any day, and my guess is it will be during the most inconvenient time possible. How much of your time will go into doing maintenance, or arranging for it to be done? Maintenance hassles are the top reason people get out of investment real estate, right after “didn’t make any money.” And while demanding year-round attention, the second home is also limiting your options when vacation time rolls around. Let me ask you, “Do you see yourself vacationing in the same place every year for the next 20 years?” Most people would say “no,” and there’s the rub. There are more than 10,000 homes available for rent on vrbo.com in California alone. Why limit yourself to one of those?