Making a Move on a Vacation Home

At the height of summer, as Americans visit their favorite beach getaways and mountain retreats, many will engage in an increasingly popular activity -- scouting for a second home. Others, who once again haven't spent as much time in the homes they already own, may dream about the riches of renting.

Last year, the number of second homes purchased as vacation or investment properties reached a record 445,000, or about 5% of all U.S. homes sold, according to the National Association of Realtors. And demand over the next decade is expected to remain as high as temperatures in August.

The quest for second homes is driven mainly by middle-class baby boomers seeking restful hideaways, investment alternatives to the slumping stock market and future retirement homes. (See the chart below for a demographic profile of owners.)

"For most people, buying a second home is very much a lifestyle choice, but the investment potential has increased given strong price appreciation," said David Lereah, chief economist for the National Association of Realtors, on the results of his association's benchmark 2002 study of second homes.

The association also views the upswing in second-home purchases as a desire by some investors to diversify their assets. Before 2000, only 7% of buyers sold stocks or bonds to help pay for a second home, while after the major market downturn of that year 16% did so.

Giving the second-home movement a considerable boost is the 1997 liberalized tax law that lets homeowners reap sizable tax-free gains from the sale of their primary residences multiple times.

Generally, homeowners who sell their principal residences where they have lived for two of the past five consecutive years can pocket as much as $500,000 in profit free of capital gains if married, or as much as $250,000 if single. They can do this repeatedly if they follow the tax rules.

Home Away From Home
Second-home market at a glance
  • Between 1980 and 2000, the number of homes more than doubled to 3.6 million.
  • The median age of home-buyers in 2002 was 47 years old.
  • The typical owner is 61 years old with household income of $76,900, has owned the property for nine years and purchased it for recreational use.
  • People who buy close to big cities are more likely to have families and to feel stressed by time. Owners spend a median of eight weeks per year at their properties.
  • Most owners live a median distance of 185 miles away, while one-third were less than 100 miles away.
  • Vacation homeowners identified their homes in this way: 31% had cabins or cottages, 27% had a detached single-family house, 17% a mobile home, 11% a multifamily unit and 6% a two-to-four unit structure.
  • Some city dwellers downsize their primary residence to add a second home.
  • States with a large number of second homes have significant coastal waters: Florida, Michigan and Maine.
  • Middle-class buyers are becoming a presence in such once-isolated areas as the Finger Lakes in upstate New York and more remote sections of New Hampshire.
  • The terrorist attacks of Sept. 11 increased people's desire to find a haven from potential targets.
  • Telecommuting has allowed a growing number of vacation homeowners to use their weekend retreats interchangeably with their first homes.
Sources: American Demographics, National Association of Realtors

With homes prices doubling and even tripling in some parts of the country in recent years, financial advisers report that vacation homes are often employed to take advantage of this tax-free gain.

"We are seeing a tremendous amount of activity in the second-home market here in Florida," said Douglas P. Hanke, CFP, EA, with Florida Financial Advisors, Inc. in Tampa. "For people that have acquired many different homes over the years, the new tax laws can be used over and over as they move from home to home. Even if the homes have appreciated more than the $250,000-$500,000 exclusion amounts, this is still a good deal."

While maintaining a second home isn't always a picnic at the pond, tax breaks both short and long term can help make it a pleasurable and profitable endeavor.

One note of caution: Prices might already be overheated in certain desirable waterfront locations. In Florida, for example, renovated units at one Holiday Inn are selling for $1 million each, and along the Great Lakes waterfront condominiums can go for $500,000 and up. So prospective buyers should shop with care.

When it comes to taking short-term tax breaks, owners of second homes usually fall into one of three categories.

Vacation Home

The majority of owners, or 51%, keeps their second properties as true vacation homes and has little or no interest in renting them, according to the realtors association.

Owners can deduct the property taxes on a second home and any mortgage interest, up to a limit. The tax code allows homeowners to deduct mortgage interest on two homes, up to $1 million.

But even a vacation owner, or any homeowner for that matter, can enjoy some tax-free rental income. Taxpayers who rent their homes, or vacation homes, for less than 15 days during the year don't have to report the rent as income (nor do they get to take any related tax deductions).

"It's completely tax free," said Bob Trinz, a senior tax analyst at RIA, a provider of tax information to tax professionals. "I assume a lot of people in Manhattan will be doing that with the convention."

Vacation and Rental Home

A home can be treated for tax purposes as both a residence and as a rental unit with certain tax deductions. The owners must occupy the home for more than 14 days in general or more than 10% of the days the property is rented to others at fair value.

Rental income can be offset with deductions prorated for the rental period for expenses such as mortgage interest, real estate taxes, insurance, utilities and maintenance, said Trinz. Homeowners can also claim depreciation, a deduction for the wear and tear of property, for the rental period.

But the deductions can't exceed the rental income under most circumstances. "It's basically a common-sense rule," said Trinz. Assuming the taxpayers meet the usual qualifications, they can still deduct the share of the mortgage interest for the portion of the year used for personal use.

Rental Property

A vacation home is treated mainly as a rental property if the owners don't use it more than 14 days or more than 10% of the days it is rented out. A different set of more generous tax rules apply.

Generally, said Trinz, income and deductions are treated as passive in nature. If the deductions exceed the rental income, usually the loss can only offset other passive income such as investment interest and dividends, until the property is sold.

But, if the owners actively participate in managing the vacation rental, then they can shelter non-passive income with up to $25,000 of rental-related losses. The $25,000 limit begins to phase out for married couples with an adjusted gross income above $100,000 and phases out completely when that income reaches $150,000.

When the home is sold, however, the owners must repay tax on deductions taken for depreciation.

Long-Term Gain

Owners of second homes who don't actively rent them could nonetheless use them to enjoy some hefty real-estate profits, thanks to the capital-gains exclusion in a 1997 tax law.

John Wimbiscus, CFP with Trinity Financial Advisers LLC in Chicago, knows of one family who built a large second home on an island along the now fashionable South Carolina coast 10 years ago. When they later sold their primary residence in Chicago, they retired to their island home with a big tax-free gain. They built the home large enough to have their extended family visit every summer.

Wimbiscus said he sometimes encourages clients to think ahead when shopping for a vacation home, to buy a larger home now rather than later. "It's the financial adviser's job to get them thinking about retirement," he said.

Some Chicagoans, he said, will sell their primary residence, buy a big retirement home in a less expensive area, but keep a small condo or apartment in the city.

Hanke, the Florida planner, pointed out that the tax law allows those who divide their time six months in New York City, for example, and six months in Florida for at least four years, to sell both properties and claim the tax-free gains on both -- as long as they used each as a principal residence equally. Then they could do it all over again.

Eventually, advisers say, after selling their first home in the city at a profit, retirees might want to sell their second homes at another tax-free profit and use the proceeds to move into a retirement community.

Before joining TheStreet.com, Ann Perry was the personal finance columnist for The San Diego Union-Tribune. She is the author of "The Wise Inheritor: A Guide to Managing, Investing and Enjoying Your Inheritance" (Broadway Books, 2003). She has a B.A. in English and Communications from Stanford University and a master's degree from the Columbia University School of Journalism. She can be reached at Ann.Perry@thestreet.com.

More from Opinion

It's Just Not Smart For Investors to Ignore the Threat of a Trade War

It's Just Not Smart For Investors to Ignore the Threat of a Trade War

To Think a Trade War's Still Just a Threat Is the Dumbest Thing on Wall Street

To Think a Trade War's Still Just a Threat Is the Dumbest Thing on Wall Street

Flashback Friday in Politics: Trade Wars, Manafort, Immigration Dominate Minds

Flashback Friday in Politics: Trade Wars, Manafort, Immigration Dominate Minds

Microsoft and Sony's Rumored Game Console Plans Bode Well for AMD

Microsoft and Sony's Rumored Game Console Plans Bode Well for AMD

Apple Supplier Jabil Is Tumbling, But Its Sales Momentum Remains Strong

Apple Supplier Jabil Is Tumbling, But Its Sales Momentum Remains Strong