You’ve found yourself wanting to purchase a second home. Whether for personal use, a rental or a hybrid of both, there are a variety of financial considerations to keep in mind.

1. Can you afford the purchase?

The first question you should ask yourself when considering the purchase of a second home is whether or not you can afford the purchase. You should evaluate your financial plan, and finances, as well as the costs associated with properties you may be interested in. Just like with any home purchase, round up your budget to include additional expenses for items like furnishings and repairs. If you plan to finance your second home, talk to lenders and get pre-qualified. Depending on your financial situation and the amount of cash needed, you may consider refinancing your primary home to pay for your secondary. Rates are often lower on your primary residence, and this could help with financing depending on the location of the second property.

2. What is the investment value of a second home?

Consider the investment value of any home you evaluate for purchase as a second property. If you have already determined the costs associated with the new property, consider how much you will personally use the home. What is your total cost-per-use, and how often can you afford to use the property yourself, versus potentially needing to rent the home to recover a portion of your expenses.

Also consider the potential investment appreciation in a normal market compared to what could be a shorter-term rise in prices. Recently, home prices have risen at record levels, especially in areas where second homes are popular due to the increase in remote work capabilities and other factors. When you consider potential appreciation on a second home, it is wise to use a conservative rate that is reasonable for the long-term.

To help put this into perspective, according to the S&P/Case-Shiller National Home Price Index, home prices have increased by an average of 3.2 percent per year between the years 1891 and 2019.  You should consider the value and growth of this investment as you would any other asset on your balance sheet, but also keep in mind that during certain market cycles, a home, unlike other investments, may not be liquid. As such, you should be always be mindful of the amount you invest in real estate as it relates to your overall net worth.

3. Do you know the laws and expenses associated with renting out your second home?

One of the biggest reasons you may consider buying a second home, beyond for personal use, is to create rental income. Whether you are purchasing the property exclusively as a rental, or you plan to rent just enough to cover your expenses, there are certain laws and expenses you should be aware of.

Airbnb has become a popular platform for rental properties, particularly short-term rentals. However, New York City bans short-term rentals of under 30 days from the city unless the property is a shared space with the owner present. You need to be aware of the rental laws and ordinances specific to the area you are considering.

In order to have a rental, you will need to have a system to collect rents, hold deposits, and set aside cash for upcoming maintenance and repairs. A good rule of thumb for cash to hold aside is 3-6 months’ worth of expenses for the property. Other expenses you should account for are things like homeowner’s association dues, cleaning services, property taxes, and insurance. Will you have a property manager handling your rental property and communicating with tenants? These are all things you should consider.

4. Will you have to adjust your insurance to account for new risk?

While a second home may be fun, you should think carefully about the additional risk exposure it could also carry. Perhaps the property is located on a body of water, or you will have various renters in and out. You should discuss any possible new risk and adjust your insurance accordingly. You may want to increase your umbrella coverage as a result of the new purchase. In addition to insurance, you may consider owning the property within a Limited Liability Company (LLC) in order to protect your personal assets in the event of a lawsuit, particularly in the case of a rental.

5. Are you aware of tax implications of owning a second home?

For tax purposes, your second home will either be classified as a personal residence or a rental. The distinction, according to the Internal Revenue Service (IRS), is made based upon how many days per year you rent the property. If the property is rented for 14 days or less, it is considered a personal residence; over 14 days it is a rental. According to the IRS, if a dwelling is both used as a residence and rented for fewer than 15 days, you are not required to report any of the rental income and don’t deduct any expenses as rental expenses.

Deductible expenses on a second home will vary based upon use. If your second home will be mixed use, generally you will divide your total expenses between rental and personal use based on the number of days used for each purpose. Also keep in mind that while mortgage interest is deductible on up to $750,000 of debt, you may not deduct mortgage interest on property classified as a rental.

If you own your primary residence, you are likely familiar with the principal residence exclusion provided by the IRS. This exclusion allows up to $500,000 of gain for a married couple, or $250,000 for a single filer to be excluded from income on the sale of a home assuming certain qualifications are met. The qualifications are that you must own and occupy the home as your principal residence for at least two of the five years prior to its sale. Your second home may not be your primary residence, and this is an important tax concern to be aware of in the event you are considering a sale.

A second home can provide a much-needed getaway, cherished family memories and income. However, it’s important to understand the risk associated with owning two homes and how the investment fits into your financial plan. Reach out to your Badgley Phelps adviser to discuss further if you’re interested in purchasing a second home.

Originally published on December 16, 2021