3 Things to Know Before Buying a Second Home
Like many people, you may wonder if owning a second home or vacation property is a good strategy for adding real estate to your investment portfolio. Owning a second home can be an effective way to diversify your assets, generate income, and build equity. However, like any investment, it’s not without risk. If you’re thinking about buying a vacation property or other real estate, take a few moments to consider the three questions below.
1. Does adding real estate to your investment portfolio align with your financial plan?
Adding real estate to your investment portfolio can be a great way to diversify your income sources and assets. However, since different real estate investments provide different benefits and risks, it’s important to determine your overall goals before adding real estate to your investment portfolio. Are you seeking additional income, a way to further reduce taxes on current income, a hedge against stock market risk, a retreat to enjoy with family and friends, or a combination of these?
You also want to consider whether an active or passive approach to managing real estate assets is right for you. For example, if you’re seeking additional tax benefits to offset your income by adding real estate to your investment portfolio, but don’t want to take an active role in managing a property, such as a beach or lake house, you may want to consider publicly traded real estate investment trusts (REITs) or funds that invest in real estate.1 These methods allow you to add real estate to your investment portfolio without having to commit a lot of money upfront or actively manage any properties.
2. What are the potential financial benefits and risks of investing in a second home?
Most people buy a vacation home with the expectation that it will appreciate over time and/or provide an income stream as a rental property. While these benefits can prove lucrative, adding real estate to your investment portfolio is never without risk. For example, if real estate prices are high in the location where you intend to buy, you may have to pay top dollar for the property you want. In addition, expenses including mortgage payments, property taxes, insurance, utilities, maintenance costs, and homeowner’s association fees can add up quickly. You’ll also need to plan for unexpected expenses, such as weather-related events or damage from renters.
On the other hand, if you frequently visit the same destination for family vacations, adding real estate to your investment portfolio through ownership of a vacation property may provide a satisfying return on investment vs. renting someone else’s property.
While potential tax benefits, income generation, and appreciation can make owning a vacation home very attractive, it’s important that the downpayment and cost-to-carry a second property don’t have an adverse impact on your cash flow but, instead, align with your budget and long-term financial plan. In other words, you don’t want to create a situation where adding real estate to your investment portfolio renders you cash poor or jeopardizes your ability to achieve other important lifestyle goals.
3. What are the tax implications of adding real estate to your investment portfolio?
In general, you may be able to deduct certain expenses associated with adding real estate to your investment portfolio through ownership of a second home. If the property is considered a personal residence, you may be able to deduct some or all of your mortgage interest for the tax year if you use the home for more than 14 days or 10% of the days that you rent it out, whichever is greater. When you consider adding real estate to your investment portfolio, be aware that if your second home is considered a rental/investment property, you’ll need to report any rental income to the IRS if you rent your home for more than 15 days per year and your personal use of the property does not exceed 14 days per year or 10% of the number of days the home was rented. In this case, you can deduct expenses for the rental, including maintenance and utilities.
If you own two houses, as a result of adding real estate to your investment portfolio, and both are strictly for personal use, you will likely owe two sets of property taxes. It’s important to understand that under the Tax Cuts and Jobs Act of 2017, there’s a $10,000 limit ($5,000 if married filing separately) for state and local taxes paid, which includes property taxes. This $10,000 maximum could limit your ability to take a deduction for property taxes on your first and second homes. However, if the second home is considered a rental/investment property, you would have the ability to deduct all or a portion of the property tax without the $10,000 limitation.2
Another tax issue to know about before adding real estate to your investment portfolio is the ability to deduct mortgage interest. For homes purchased after December 15, 2017, you can deduct the mortgage interest you paid during the tax year on the first $750,000 of your mortgage debt for your primary and/or a second home. (If you are married filing separately, the limit drops to $375,000.) So it’s not hard to reach this limit where the combined mortgage debt on your primary and vacation homes exceeds $750,000. There are other criteria that must be met to qualify for the mortgage deduction as well.
Before adding real estate to your investment portfolio, keep in mind that tax rules are complicated and may differ depending on your specific situation and the location of your home. Take time to meet with a qualified tax professional well in advance of purchasing a second home.
At Return on Life® Wealth Partners, our tax and wealth planning professionals can help you develop a tailored strategy for adding real estate to your investment portfolio. For more on this topic, be sure to listen to my latest podcast episode of Frank Wealth Insights. To learn how we can help you and your family pursue the Return on Life® you desire, contact us today for a free consultation.
About Return on Life® Wealth Partners
Return on Life Wealth Partners is an independent Registered Investment Advisor (RIA) founded in 1994, with headquarters in Cleveland. The team provides comprehensive wealth planning services to individuals, families, and business owners. By examining clients’ lives before their money, Return on Life® aligns its advice with clients’ values. With access to its Complete Family Office (CFO)SM and Personal CFO™ services, Return on Life® Wealth Partners aims to help clients achieve the milestones that matter most to them. This personalized approach also extends to the institutional and corporate retirement plan services available through 401(k) Prosperity®.
1Investing in REITs involves a high degree of risk. Some, but not all, of the risks and uncertainties that an investor can expect are risks related to: acquiring, owning and selling real property and real estate investments, including risks related to general economic and real estate market conditions, the risk that the REIT’s properties become too concentrated (whether by geography, sector or by tenant mix) and the risk that the sales price of a property might differ from its estimated or appraised value; property valuations, including the fact that the REIT’s appraisals are generally obtained on a quarterly basis and there may be periods in between appraisals of a property during which the value attributed to the property for purposes of the REIT’s daily accumulation unit value may be more or less than the actual realizable value of the property, etc. This summary of risks does not address all the risks an investor may experience. Additional discussion of the risks can be found in the “Risk Factors” section of the REIT’s prospectus.
2Publication 527: Residential Rental Property, https://www.irs.gov/pub/irs-pdf/p527.pdf
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific tax or legal issues with your qualified advisors.
The opinions expressed and material provided are for general information purposes only.
