In the market for a second home? You’re not alone. Low interest rates and the COVID-19 pandemic have sparked a buying boom in second homes—whether to serve as a personal getaway or to generate rental income—according to data from the National Association of Realtors.1
However you utilize a second home, it’s a substantial investment—one that’s subject to different rules than your primary residence. “Whether or not you’re using it for rental income, a second home comes with its own set of financial considerations,” says Hayden Adams, CPA and director of tax and financial planning at the Schwab Center for Financial Research.
Here, then, are the factors to consider when buying, renting, and selling a second home.
Once you’ve found the right home for your needs, it’s time to figure out how to pay for it. “Paying in cash is one option, though in a low-interest-rate environment that money might be put to better use in the market,” says Ken Szymanski, a managing director at Charles Schwab Banking & Trust Services.
If instead you decide to borrow to fund your second home or investment property, 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. Jumbo loans—or those that exceed $548,250 in most counties in the United States—may require heftier down payments and have higher interest rates, closing costs, and fees. Under the Tax Cuts and Jobs Act of 2017, you can deduct the interest on up to $750,000 worth of such loans (married couples who file separately can deduct up to $375,000 each). Note that for homes bought before Dec. 16, 2017, you can apply the higher limit of $1 million (or $500,000 for married couples filing separately) for interest deductions.
- 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: This refi approach replaces your existing mortgage with one that carries a larger balance. The difference between the two loans is 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 lending: A non-purpose* line of credit from a bank can allow you to borrow against the value of your non-retirement assets while helping to keep your investment strategy on track (see “Another way to borrow,” below).
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 calculate what you’re paying monthly for the upkeep on your current residence and assume a similar outlay for your second home.
Also, 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 a rental property alone would provide. A tax advisor can help you maximize the available deductions while helping you fulfill your tax obligations. “Some people think of a rental property as a hobby, but it’s not—it’s a business,” Hayden says. “That’s certainly how the IRS sees it, and that’s how you should see it, too.”
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.
Also 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 are evolving rapidly in response to the rise of vacation rentals through companies such as Airbnb. 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.
Owners should also strongly consider setting aside emergency funds to avoid selling securities in a down market to pay for any unexpected expenses.
Finally, Hayden urges those planning to rent out a second home to treat it as a separate business entity. “If your rental isn’t structured properly, any renter who brings a lawsuit could potentially take your car, house, or hard-earned savings,” he says. For example, registering a business as a limited liability company (LLC) can help protect your assets in the event you’re sued—as can liability insurance.
Once it comes time to sell a property, it’s a good idea to meet with a tax professional first.
In particular, 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 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 like-kind exchange can be done multiple times, potentially deferring for many years the taxation of any capital gains.
“A team effort”
Buying a second home involves a lot of work, not only in advance of buying but throughout the rental process and eventual sale. Finding a reliable team of professionals—an accountant, an attorney, a real estate agent, and possibly a property manager—can help. “More so even than your primary residence, successful second-home ownership is a team effort,” says Hayden.
And of course an experienced financial advisor or wealth strategist can help you to realize your dream of second-home ownership to begin with.
1“Vacation Home Sales are Getting a Pandemic Boost,” National Association of Realtors, 11/09/2020.
What You Can Do Next
See how Schwab Bank’s home lending program provided by Quicken Loans and other lending solutions can help you take the first steps toward a second home.