Investing in vacation properties

What are the advantages?

Apart from the obvious benefits of having a permanent vacation destination, as well as a familiar place to escape to and relax, owning a vacation property has other advantages.

An investment with a tangible use

Much like your primary residence, a vacation property is an asset that has practical uses. You're not just sitting back waiting for it to provide income or to rise in value, but you're getting a present use out of it in the form of a vacation escape.

You can rent it out if you need extra income

You can keep the property primarily as a vacation home, but if money ever gets tight you can always rent it out for income. And since it is a second home that will be easier and less disruptive to do than it would be for your primary residence.

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It will likely rise in value in the long term

Like most forms of real estate, vacation properties will rise in value over time. And during speculative periods in the real estate market, the value increase on vacation property can be spectacular.

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It's a potential retirement home

Vacation property can provide the owner with the ability to “test drive” a home as a potential retirement home. You can buy the house early in life, get comfortable with the area it's located in, and payoff the mortgage in time for retirement. That will free you up to sell your primary residence to increase your retirement portfolio. In that way a major component of your retirement plan will be taken care of while you're enjoying the home.

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Vacation property prices are depressed in much of the country

This is bad news if you own a vacation property in an area where real estate prices have been particularly hard-hit. But if you're looking to buy a vacation property in such an area, the timing couldn't be better. In many traditional vacation property hotspots, like Florida, Nevada, and Arizona, prices are now well below their peak levels. If you're a buyer, entire vacation property markets are now on sale!

Read more: How to create wealth by investing in real estate

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What are the risks?

Vacation property tends to have wider price swings than other property types. During real estate booms, it can rise in price much faster than residential property, not the least of which because it tends to attract more affluent buyers. But in down markets prices can fall faster too.

Vacation property is luxury real estate, not the basic roof-over-your head type. It’s more discretionary than it is necessary, and that means the market for it can dry up much more quickly. When it does, prices can crash even when the general housing market is stable.

It’s often located in environmentally volatile areas that can physically threaten not just the property itself but the entire surrounding community. Waterfront locations are common, which opens the possibility of flooding or ocean storms. A single severe coastal storm could drop property values overnight.

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Income tax considerations

The Internal Revenue Service (IRS) has very specific rules in regard to vacation properties. The dividing line between classifying the property as a vacation home or as an investment property is defined by the number of days that you as the property owner occupy it for personal use.

If you use the property for personal use for more than the greater of 14 days, or more than 10% of the number of days it’s rented out, it is considered a vacation property. If the property is rented out for more than 14 days, it’s considered an investment property.

If the property qualifies as a vacation home, you can deduct mortgage interest and real estate taxes on Schedule A of your income tax return, just as you would for your primary residence. Other expenses, such as insurance, repairs and maintenance and condo fees will not be deductible.

If the house qualifies as an investment property, you will be able to deduct all expenses connected with the property at least up to the amount of rental income received from it.

You may be able to deduct net losses on the property, but that will depend on the amount you have invested in the property that’s considered “at risk”, whether or not your participation in the investment is considered “passive“, and the level of your modified adjusted gross income. Translation: consult your tax preparer to determine the limit of rental real estate losses you can deduct.

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Vacation property and foreign money

There's one more aspect of vacation property that rates its own discussion, especially now. Earlier we discussed how vacation property prices can rise faster than the overall market during speculative booms. Part of the reason for this is foreign money.

The US has traditionally been a haven for foreign money. Wealthy foreigners often move their money here in order to escape either economic declines or political instability in their home countries. When they do, their money often flows into real estate, and much of that goes into vacation property.

There are several reasons for this. For one, foreigners are looking for a second home situation and vacation properties are perfect for that. For another, foreigners often buy into the US vacation property market after price crashes. Still another reason is that they want to live in homes that are located in areas that they've seen in the movies and on TV. Those are often vacation havens in places like Florida, California and Arizona.

Right now the vacation property market in the United States in general is depressed. At the same time, people from China and much of the developing world are pouring their money into US real estate looking for an escape hatch in a stable place. Well-to-do Europeans are also looking to move money into the US in order to escape the declining economic fortunes there.

What this all means is that we now have a rare combination of events that favor vacation property. If you're willing to accept and deal with the risks of investing in vacation properties, now could be a once-in-a-lifetime opportunity.