Buying, Renting, and Selling a Second Home

Once you've found the right property for your needs, it's time to figure out how to pay for it. If you need to borrow the funds, there are several financing options open to you, including:

• A traditional mortgage: The most popular types include fixed-rate loans—typically for 15 or 30 years (generally speaking, the shorter the loan, the lower the interest rate)—and adjustable-rate mortgages (ARMs), whose interest rates reset after a fixed period of time and adjust in response to prevailing market rates. Depending on the purpose of the second home—for vacations, rental, or both—lenders may likely have stricter requirements, like a larger down payment, a liquid reserve requirement, lower debt-to-income ratio, etc. One upside of a mortgage is you may be able to deduct the interest on up to $750,000 worth of such loans (married couples who file separately can deduct up to $375,000 each) if the property is used for personal use. For homes bought before December 16, 2017, you can apply the higher limit of $1 million (or $500,000 for married couples filing separately) for interest deductions. These limitations—set by the Tax Cuts and Jobs Act of 2017—will expire at the end of 2025 unless Congress extends them. If you plan to rent your property, you may have to follow different rules regarding your mortgage interest.
• A home equity line of credit (HELOC): A HELOC allows you to borrow against the equity in your existing residence—and the interest may be deductible if the funds are used to purchase, build, or substantially renovate a primary or secondary residence, up to the limits mentioned previously.
• A cash-out refinance: Another way to use your current home's equity to your advantage can be by replacing your existing mortgage with one that carries a larger balance. The lender may require you to maintain a portion of your equity in the new mortgage, but then the difference between the two loans can be distributed as cash, which can be especially useful if you have house-related expenses over and above the new property's purchase price.
• Securities-based line of credit from a bank: A nonpurpose line of credit from a bank can allow you to borrow against the value of your nonretirement assets while helping to keep your investment strategy on track. This option does involve risk, however, and is generally suitable as a bridge loan.

However you choose to finance your purchase, do your homework to understand the considerations and risks involved in obtaining a second home. Chief among them:

• Additional debt: Taking on new debt could impact your cash flow and savings plan.
• Bigger down payment: Lenders may require a larger down payment on a second home, in which case you'll need to consider how to come up with the money without putting your other investments at risk.

Finally, be realistic about expenses. Beyond the purchase price, there are an array of ongoing costs, including repairs, utilities, and possibly homeowners' association fees. A good starting point is to ask the previous owner about their monthly expenses and the age of last replacements or repairs. You could also estimate about 2% to 4% of the home cost annually or ask the realtor about general expenses in the area.

Note that many popular vacation spots, particularly in coastal communities, are at increased risk of flooding, wildfires, and other weather-related events, so make sure you're adequately insured and at a price that makes sense.

You also need to decide up front whether you'll rent out your second home, be it occasionally or on an ongoing basis. A rental property can provide not only income but also potential tax benefits. For example, you may be able to deduct certain expenses, such as depreciation, from your annual rental income.

Keep in mind, however, that you'll likely face a host of tax obligations as well. Apart from property taxes, any rental income could potentially push you into a higher tax bracket. Also, if you use a second home as both a rental property and for extended personal use, you may not be eligible for all the deductions that a rental property alone would provide. Some people think of a rental property as a hobby, but it's not—it's a business. That's certainly how the IRS sees it, and that's how you should consider it, too. A tax advisor can help you maximize the available deductions while helping you fulfill your tax obligations.

Another question to tackle in advance: How will you interact with renters? Some owners take a hands-on approach to everything from collecting rent to making repairs, while others hire handymen and even full-service property managers who can find suitable renters, help refurbish the property between tenants, and do everything in between. Such white-glove service comes at a cost, but it can be especially helpful with a property in a distant locale.

You should also strongly consider setting aside a reserve for the rental property. This can help you avoid dipping into your retirement savings or selling securities in a down market to pay when the property is vacant or any unexpected repairs or other expenses arise.

Before you list your home, be sure to check with a real estate agent and/or your homeowners' association regarding local rental rules. These can vary by municipality and even by neighborhood, and they're evolving rapidly in response to the rise of vacation rental companies. In New York City, for example, you cannot rent out an entire apartment or home to visitors for fewer than 30 days, even if you own or live in the building.

Finally, it's best to treat your rental as a separate business entity. If you don't structure the property properly, any renter who brings a lawsuit could potentially take your car, house, or hard-earned savings. For example, registering your rental business as a limited liability company (LLC) can help protect your assets in the event you're sued—as can purchasing liability insurance.

Once it comes time to sell a property, it's a good idea to meet with a tax professional first.

Many owners are surprised to learn that any depreciation in the value of a rental property claimed for tax purposes reduces that property's cost basis. If the property is later sold for a profit, the seller will generally owe up to a 25% tax on any previously claimed depreciation before being subject to potential capital gains taxes.

What's more, if the property has not been your primary residence for at least two of the past five years, you may not qualify for the capital gains exclusion, which allows you to shield the first $500,000 in profit from capital gains taxes if you're married and file jointly ($250,000 if you're a single filer). The rules surrounding the capital gains exclusion can be complex, so it's best to check with an accountant before attempting to claim this exclusion for rental properties, in particular.

Another potential option to discuss with a tax advisor is a 1031 like-kind exchange, which allows you to roll the proceeds from one rental property directly into another, thereby deferring any capital gains taxes until the second property is sold. A 1031 exchange can be done multiple times, potentially deferring the taxation of any capital gains for many years.

Buying a second home involves a lot of work, not only in advance of buying but throughout the rental process and eventual sale. Successful second-home ownership is a team effort—consult with an accountant, an attorney, a real estate agent, and possibly a property manager. And of course, an experienced financial advisor or wealth strategist can help you to realize your dream of second-home ownership to begin with.