Updated on December 21, 2020 by Michael Klipper
The most obvious statement to make these days is that 2020 has been a very strange year. The economic environment, especially for small businesses, has been a challenge to say the least. Yet when you look around at our financial indicators like the Dow Jones or the real estate market, you would think that things are the best they have ever been. Well, in some cases, this is true. In particular, one area that has seen a significant increase in value is the vacation home market. Specifically, vacation home areas that are near metropolitan areas and are drivable. If you are in the Philadelphia metro area, like I am, that means the Poconos and the Jersey Shore. These areas have seen a huge increase in values, and the rental market is on fire. You may know a friend or family member who recently tried to purchase something, only to lose out because the house was under contract within 24 hours for over the original asking price. So why is this happening?
People are spending more time in their homes than they ever have before. Many people are no longer traveling into the office for work and are now stationed in their extra bedroom or kitchen. Kids are not getting on the school bus but instead logging into a virtual classroom from their bedroom. This has some benefit (reduced travel expenses and spending more time with the people we love), but it also makes a lot of us stir crazy. So since many of us only need a computer and strong internet connection, why not do that in a house that has a slightly better (or maybe just different) view? So people are going to the mountains and to the sea. This has created an incredibly strong market for those that own a property that is available for rent on platforms like Airbnb or VRBO. Many people see this and are deciding to take the plunge and invest in a beach home or Pocono retreat. So what is important to know if you are considering such an investment?
UNDERSTAND YOUR PRICE POINT
How much money are you able to borrow from the bank? How much of a down-payment are you required to make out of pocket? Where is that money coming from? It is important to understand your borrowing power and how much you have to invest to zero in on the properties that fit your budget. We always recommend talking to multiple banks/mortgage companies. Some banks have an extensive lending portfolio for second homes; other banks do not. So the “deal” you may be able to get from one bank might not be the same from the next. So call around, get referrals from friends and family, and see what your purchasing power is.
UNDERSTAND YOUR CASH FLOW
Once you understand your price point, you need to understand what similar properties rent for and what their season looks like. Let’s say you have $100,000 to put down, and you are approved for a $500,000 home purchase. Not all $500,000 houses perform the same. An older home in a great location (i.e. near the water or a ski resort) might need more work but also might be easier to rent. That same $500,000 might buy you a brand-new home that is a long walk from the “desirable area,” and thus, the renting season is not quite as long. So do your homework. Focus on specific areas, learn about the rental trends, call other landlords in the area, and get inside information. See what houses rent for in the off-season, see what a weeklong stay during the busy season can produce, and everything in between. This will allow you to understand your estimated rental income over the course of 12 months. However, this is just half of the battle. Once you know your potential rental revenue, now you need to estimate your annual expenses. What is your monthly debt service going to be? What is the house going to cost to heat? What can you expect for annual repairs and maintenance? How much furniture do you have to replace each year? How much will a rental service like VRBO charge you each year for the rents you book? Understand the prospective cash in and cash out to make sure that you will be cash-flow positive (this means that you will bring in more money than you will put out each year).
UNDERSTAND THE 14 DAY RULE
The 14-day rule is fairly simple: If you rent a house for less than 14 days over the course of the year then you are NOT a landlord. It is a true personal property, and any income you do receive during the 14 days or less that you rent does not need to be included in your income. If you rent the house for all BUT 14 days (i.e., you only use it for personal use 2 weeks or less), then you are considered a full-time landlord, and the house and all of the expenses and income need to be recorded on your tax return. You can deduct nearly all expenses that you incur for maintaining the home, but you also have to include 100% of the income you receive during the year. If you rent it for more than 14 days but you also use the house personally for more than 14 days, then you have to allocate the % of days you used it as a rental property. That % is what you are allowed to deduct on your personal tax return. Example – If you rent out the house for 150 days during the year but also spent 35 days there for personal use, you would take 150 / 185, which is approx. 81%. That 81% is the portion of allowable expenses you can deduct. So 81% of the repairs, utility costs, mortgage interest, etc., would be put against the rental income you collected.
UNDERSTAND HOW RENTAL ACTIVITY GETS FILED ON YOUR TAXES
If you own the house solely (including with your spouse), then this rental activity gets filed within your personal income tax return on Form Schedule E. All applicable rental activity gets reported and any profit is taxable based on your marginal tax rate. However, no self-employment tax is payable if you have a profit. If you have a tax loss, up to $25,000 of loss can be taken on your return in any given year. If you own the property with anyone other than your spouse, a partnership tax return will need to be filed. This is a pass-thru entity, and any share of the income or loss gets reported on a K-1, which then gets input into your personal tax return. The filing deadline for a partnership return is one month earlier than an individual return (i.e., March 15th).
UNDERSTAND HOW DEPRECIATION WORKS
One of the most misunderstood parts of owning a rental property is depreciation. It is misunderstood quite frankly because, in general, it doesn’t make that much sense. You are partially making this purchase because you expect that the property in question will increase in value over time (i.e., it will appreciate). However, the IRS (and your state) allow you to take a depreciation deduction on your tax return for the cost of the physical structure. This depreciation period is 27.5 years. So how exactly does this work?
Well, let’s say you purchase that $500,000 property. In general, your accountant (hopefully us) will treat 15% of the value of that property as the land value. So, in this case, that would be $75,000. This amount does not get depreciated. The remaining portion, $425,000, would be the cost basis of the physical structure. Every year you own the property, you can take a tax deduction of $15,454 ($425,000 / 27.5). Wow, this is great. What is there to understand? Well, there is a huge catch. This depreciation reduces the cost basis of your property. So when you sell the house down the road, you essentially will pay back any tax benefit you received.
Example – You owned the $500,000 property for exactly ten years. Over ten years, you took $154,540 of total depreciation expense. Let’s say you sell the property for $600,000. Your gain is calculated by taking the selling price and reducing it by the cost of $500,000 and adding back the depreciation expense. So your gain would be $600,000 – $500,000 + $154,540 = $254,540. So depreciation is just a short-term deduction that you will eventually have to pay back.
Ok, I just threw a lot at you. There is a lot to think about when considering purchasing a vacation rental, and many things we haven’t even gone over yet. So ask a lot of questions and do your homework. As always, we are here to help in any way that we can.
