5 Questions to Ask Before You Buy a Vacation Home

We reveal five questions you should ask before buying a vacation and/or second home.

By: Morris Dye

1. Where's a good place to buy?

Buying a vacation home is a bit like getting married: After enjoying the destination as a casual visitor, it's time to make a long-term commitment and settle down.

Choosing where to buy depends largely on where you live, what you can afford, and whether or not you will rent out the property when you're not using it. So before saying "I do," give some serious thought to these core issues:

How will you get there?

According to the National Association of Realtors (NAR), more than 80 percent of vacation-home buyers choose locations within driving distance of where they live, with about half of all owners opting for properties within 50 miles of their primary residence. Proximity to your home is especially important if you plan to visit the property frequently. Much as you loved your trip to Fiji, you're not likely to fly to the South Pacific for a three-day weekend.

Will you need rental income?

NAR statistics show that most owners of vacation homes do not rent out their properties, but if you can't quite make the mortgage payments without some rental income, it's best to choose a popular destination where demand for short-term lodging is high. Experts say the most desirable spots are near oceans, lakes or rivers, or at mountain recreation areas.

Will the location suit your future lifestyle?

While vacation homes can gain value over time, the NAR advises that short-term speculation on residential real estate is risky business, and most buyers settle on a property they'll enjoy for many years to come. Planning for long-term enjoyment can mean buying a place that's big enough for a growing family, or choosing an area with a range of recreational opportunities to accommodate evolving interests.

Mountain biking may be your current obsession, but what happens if you decide to take up golf or fly-fishing? And if you're buying a home for future retirement, be sure to look for the kind of structure and location where seniors can live comfortably. Thirty years from now, will you want to climb stairs to reach the master bedroom, or drive a rutted dirt road to your rustic cabin in the woods?

2. Can you afford to buy a second home?

Crunching the numbers is a crucial first step for anyone who's thinking about buying a second home. Otherwise, that dream vacation getaway could become your worst financial nightmare. David Hehman, CEO of EscapeHomes.com, advises buyers to look beyond the sale price to calculate the true cost of ownership.

Key factors include:

Financing

Hehman says mortgage companies may charge higher interest rates and/or require higher down payments for second homes, but there are creative ways to finance the deal without dipping into your child's college savings plan. It's often possible to leverage the equity in your first home, or even divert pretax funds from an IRA. Hehman adds that with the bewildering array of financing options available, it's wise to seek assistance from an experienced mortgage broker instead of dealing directly with a single lender.

Insurance

There's a flip side to the bucolic settings and quaint seaside communities many buyers crave: The most desirable areas may have a higher risk of natural hazards such as hurricanes, floods or forest fires, so insuring that little slice of paradise could easily leave your budget in ruins. To avoid unpleasant surprises during escrow, Hehman advises buyers to get several insurance quotes before making an offer.

Maintenance

Buyers often underestimate the cost of maintaining a home, particularly when it comes to roof jobs, exterior paint and other pesky long-term projects we all like to avoid. Hehman says a good rule of thumb is to set aside about 2 percent of the home's value each year for maintenance. For professionally managed rental properties, he says, buyers should expect the management company to pocket anywhere from 20 to 50 percent of the rental income.

3. Is it a smart investment?

Recent figures from the National Association of Realtors show an upward trend in the number of second homes purchased for investment purposes, with rental properties outnumbering vacation homes by a wide margin. Property values do fluctuate, of course, but according to Tom Kelly, co-author of How a Second Home Can Be Your Best Investment (McGraw-Hill), sinking a portion of your net worth into residential real estate can be a great way to diversify your portfolio.

Kelly explains that for investors who currently lack the means to acquire an idyllic leisure-time retreat, the path to owning a vacation home can begin with a more affordable and utilitarian rental property close to home. "That becomes a real financial nest egg for you," he says, "and down the road you can build equity and trade it for a place you've always wanted to spend time."

When you do invest in a vacation home, Kelly says he believes it's wise to look for a place that has value as a part-time rental property as well. "Find something you like that you also can rent out, because most of the time you're not going to be able to use it as much as you think."

As with any investment, Kelly adds, due diligence is key. Before making an offer, set aside your rose-colored glasses for a moment and learn all you can about local zoning laws, construction standards development plans and other factors that may adversely affect the long-term investment value of the home you plan to purchase.

4. How will a second home affect your taxes?

Just like your primary home, a vacation home is likely to have a major impact when April 15 rolls around. According to the National Association of Tax Professionals (NATP), mortgage interest and property taxes on first and second homes alike may be claimed as Schedule A deductions, but to avoid unfriendly encounters with the IRS, buyers should be aware of some important differences in the way second homes are taxed.

The NATP advises that homes rented out for fewer than 15 days during a given year are considered personal-use property by the IRS. Owners are not required to report the rental fees as income, and no other deductions (aside from mortgage interest and property taxes) are allowed.

If you decide to rent out your second home for 15 days or more during the year, get ready for a flurry of additional paperwork, beginning with the requirement that all rental receipts be reported to the IRS as income. The NATP adds that operating expenses such as utilities, repairs, insurance and management fees can be deducted against the rental income, with deductions allocated according to the number of days the property was rented versus the number of days it was reserved for personal use. Travel expenses related to maintaining a rental property may be deducted in some circumstances, but no travel deductions are allowed for properties rented out for fewer than 15 days.

Unlike your primary residence, all profits from the sale of second home will be taxed as a capital gain, though it may be possible to make a end run around the capital-gains tax requirement if you move into your vacation home and treat it as your primary residence for at least two years before selling.

5. Are time shares or joint ownership good options?

A history of pushy sales tactics and shady deals has given time shares a bad reputation in the past, but lately the industry has made a concerted effort to turn over a new leaf. According to the American Resort Developers Association, more than 3 million U.S. households currently own time shares, and nearly 85 percent of owners responding to a 2002 survey said they were satisfied with their purchase. The term "time share" actually encompasses two distinct forms of vacation ownership. In some cases, buyers acquire deeded ownership of a house or condominium for a specified period of time each year, while other deals involve buying intervals of time at a resort without actually holding a deed to the property.

Technicalities aside, all time-share owners must fork out annual maintenance fees to a management company, and most contracts allow you to trade for time at other resort destinations.

Although time shares may be bought and sold like any other form of personal property, the Federal Trade Commission warns that sellers typically get less than the original price, so brace yourself for what could be a considerable loss if you have a change of heart.

The FTC also emphasizes that buyers should never sign a time-share contract before thoroughly evaluating the obligations and benefits of ownership. Shop carefully, however, and time shares can be a smart way to pay upfront for future getaways.

Another form of shared ownership is to buy a vacation property jointly with a friend or relative. Pooling resources is not a bad idea if your relationship with your sibling or fishing buddy is on solid footing. Just make sure you have a clearly written contract that spells out the details of the partnership and stipulates exactly what will happen if either party wants out of the deal.

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