Buying a Vacation Home

AskChristee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only; it is not intended to provide tax, legal, or accounting advice and should not be relied on as such. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.

What is a vacation home? A vacation home is secondary dwelling, other than the owner’s principal (primary) residence, and is used primarily for recreational purposes including vacations or holidays. You must plan to occupy the property at least part of the year.

Can I rent my vacation home? If you rent out your vacation home for 14 or fewer days a year the property is not considered an investment. However, you can pocket the rental income tax-free and potentially deduct mortgage interest and property taxes. You can’t take depreciation or deduct for maintenance.

Is a vacation home a Real Estate investment for Tax Purposes? This article assumes the vacation home will be rented for 14 days or fewer each year. However, if your goal is to aggressively rent the property then we strongly urge your consult your tax advisor regarding possible depreciation and other deductions. The tax implications for vacation or rental property can be complicated. The general rule is to establish a ratio of personal use compared to rental use.

Can you have more than one principal residence? No, only one property per family unit can be designated a principal residence at any given time.

Can I own more than one vacation home? Yes, it is possible to own more than one second home. Qualifying for another ‘second home’ loan may be more difficult. You will have the burden of proving the additional ‘vacation home’ is not an investment property. Your debt-to-income ratio will include your existing primary mortgage payment and your existing vacation home mortgage. Potential deductions for mortgage interest and property taxes may be restricted further due to ownership of the other properties.

Mortgage Rules Applicable to a Vacation Home

Available Mortgages. The only type of mortgage available for vacation homes is a Conventional loan. You cannot use FHA, VA, or USDA mortgages to purchase a second home.

Cash Requirements. Down payment requirements may be slightly higher for a vacation home. This may vary from lender to lender; however, you should expect at least a 10% down payment – 90% LTV.

Interest Rates. Interest rates are slightly higher than primary mortgages but lower than investment property loans.

Qualifying Ratios. Your debt-to-income ratio will include your existing primary mortgage as a debt. The debt-to-income ratio is [total monthly debts / monthly gross income]. Generally, monthly debts are those debts that will not be retired within the next 12 months and exclude obligations such as insurance and telephone bills. The debt-to income ratio should not exceed 45%. Unlike investment properties, vacation homes have no rental income to offset the mortgage payment. You have to qualify with income from sources other than the property you are purchasing.

Cash Reserves. When buying a vacation property, you’ll likely need to show cash reserves after closing. Generally, this will at least two months of mortgage payments in the bank (reserves). Cash reserves requirements may be higher based upon credit score and down payment.

Credit Score. Minimum Credit score requirements for a second home can be higher than for a primary home loan. Typically, a 680 or higher score is required. As with any mortgage approval process you may offset some underwriting requirements with ‘compensating factors’. The credit score requirement may be lower provided a higher down payment (25% or more) and large cash reserve available after closing.

PMI Insurance. Should your loan exceed 80%, private mortgage insurance is required and is more expensive when compared to a primary home loan.

Second Home Mortgage Property Requirements

Occupancy. Must be occupied by the borrower for some portion of the year.

Units. Unlike an investment loan, the vacation property is restricted to one-unit home not a duplex, triplex, or quadplex.

Property Standards. Similar to a primary mortgage, the property must be suitable for year-round use.

Ownership. Belonging solely to the buyer, not an LLC or corporation. You may be able to transfer title into an LLC after closing, provided that the original borrower holds a majority and controlling interest in the LLC. Check with your lender for complete details.

Availability. Cannot be subject to existing yearly lease and not operated by a management company that has control over occupancy.

Timeshare. Timeshare arrangement ownership interest is not eligible for FNMA loans.

Rental Income. If the lender identifies rental income from the property, the loan is eligible for a second home mortgage as long as the rental income is not used for qualifying purposes, and all other requirements for second homes are met (including the occupancy requirement above).

Your lender may have additional property restrictions.

Can I use a HELOC loan for cash? Yes, you may borrow against your primary home to create cash for purchase of a vacation home. However, the interest on the HELOC (Home Equity Line of Credit) may not be tax deductible (please confer with your tax advisor). Additionally, this will impact your debt-to-income ratio for qualifying for the vacation home mortgage.

Property Taxes on a Vacation Home. Some states have a residency requirement when calculating property tax rates. This could create an unforeseen expense. For example, in South Carolina, a non-owner occupied property will pay more than 2.5 times more annually for property taxes. Christee software will identify those states that impose a higher property tax rate for ‘non-owner occupied’ properties.

Closing Cost and Seller Credits on a Vacation Home. You will have normal closing cost and applicable seller credits when purchasing a vacation home. Christee software will estimate closing cost and seller credits providing you with ‘Total Required Cash’.

You will incur normal closing cost and the seller pay contribute toward closing cost. AskChristee modules will establish closing cost, seller credits, and required cash to close.

AskChristee’s ‘Vacation’ module provides a complete analysis of options for buying a vacation home. 

Tax Rules for Vacation Home

Rental Income. You are not required to report rental income if you rent your vacation home for less than 15 days per year.

Occupancy. Your property is considered a business if you use your vacation home for 14 days or fewer in a year, or less than 10 percent of the days it’s rented. Your property is considered a personal residence if you use it for more than 14 days or more than 10 percent of the days it’s rented. If you limit your personal use to 14 days or 10% of the total days you rent it out and the property is considered a business, the rules change. You may be able to deduct all eligible rental expenses and deduct losses up to $25,000 in the current or future tax years.

See IRS publication 527 for additional details.

Property Taxes. You can no longer deduct the entire amount of property taxes you paid on real estate you own. Now, the total of state and local taxes eligible for a deduction—including property and income taxes—is limited to $10,000 per tax return, or $5,000 if you’re married and filing separately. Many people who buy a second home may already exceed that limit with their first home, and so will not see additional tax savings from their second home.

Interest Deduction. Before the Tax Cuts and Jobs Act (December 2017), the mortgage interest deduction limit was $1 million. Today, the limit is $750,000. That means this tax year, single filers and married couples filing jointly can deduct the interest on up to $750,000 for a mortgage, while married taxpayers filing separately can deduct up to $375,000 each. The mortgage interest deduction is the combination of your primary and vacation loan amounts.

The mortgage debt must be “qualified personal residence debt,” which generally means the mortgage is backed by either a primary residence, second/vacation home, or by home equity debt that was used to substantially improve one of these residences.

AskChristee module ‘Vacation’ will estimate your interest and property tax deduction available to you. 

Selling a Vacation Home and Capital Gains

Primary Home. When selling a primary residence many sellers are exempt from capital gains taxes. This assumes sellers have made this their primary residence for a minimum of two out of the past five years, and their gain (or profit) on the home is less than $250,000 for single filers or $500,000 for married-filing-jointly filers.

Vacation Home. Unlike your primary home, which is typically exempt from capital gains taxes (with a few exceptions detailed later), the IRS considers a second home a “personal capital asset.” Here are a few more things you need to know:

1. Selling a vacation home is similar to selling stock: You’ll be taxed on the profits of the sale in the same manner you are when you sell other assets; the exception being your primary home.

2. If you own the home for more than a year, you’ll pay long-term capital gains taxes, and the Federal Capital Gains tax rate depends on your income. Some States also have a Capital Gains Tax. Christee will calculate State Capital Gains tax, where applicable.

3. If you own the property for less than a year, you’ll pay short-term capital gains taxes, and the rate is the same as your ordinary income-tax rate. For most taxpayers, it’s advantageous to wait at least a year after purchasing a second home before selling.

By making your second home your primary home, you could potentially lessen the capital gains burden. First, you would need to live in the second property for at least two years out of the five years prior to selling it. This would qualify the property as your primary residence. Also, to be eligible for the exclusion, you cannot have taken the capital gains exclusion on the sale of another home during the two-year period prior to the sale of this new primary residence.

Christee will provide a Capital Gains estimate for your vacation home.

Please click here to launch AskChristee’s ‘Vacation’ module.

Some States may impose an additional tax on the sale of primary or vacation homes, at time of sale, if you are not a resident of that State. Please consult your tax advisor.