Financing a Second Home

If you're thinking of buying a second home, be sure to crunch the numbers first. Here are some tips to make sure your dream vacation getaway doesn’t become your worst financial nightmare.

If you want to avoid higher interest rates and bigger down payments often required in buying a second home, try leveraging the equity in your first home or diverting pre-tax funds from an IRA.

• Consider working with an experienced mortgage broker, rather than one lender.
• Calculate the insurance costs. Many desirable areas have a higher risk of natural hazards such as hurricanes, floods or forest fires. Get several insurance quotes before making an offer.
• Set aside about 2 percent of the home's value each year for maintenance costs. For professionally managed rental properties, expect the management company to pocket anywhere from 20 percent to 50 percent of the rental income.
• If you can't afford your dream vacation home, start with a more affordable and utilitarian rental property close to home. You can build equity and trade it for that dream place in the future.
• Look for a place that can serve as a part-time rental property. Find something you like that you can rent out when you can't use it.
  

Learn 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.

Don't forget the tax man. Like your primary residence, mortgage interest and property taxes on a second home can be claimed as Schedule A deductions. But keep in mind the ways second homes are taxed when you use them as rental properties: 

• 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 rent out your home for 15 days or more during the year, you have to report all rental receipts to the IRS as income. 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 a second home will be taxed as a capital gain. But there may be a loophole. Move into your vacation home and treat it as your primary residence for at least two years before selling, and you may get around the capital-gains tax requirement.
  
• For more information and referrals to certified tax advisers, visit www.natptax.com.