I was recently asked by a friend what I thought about buying a vacation home, specifically a beach house.

They said they have a relative who owns one and rents it out with annual positive cash flow.

We didn’t have a very in-depth discussion, but I have been thinking about it since. Something that occurred to me is that my friends (who are not retirees) seemed to have “mixed purposes” in mind. To elaborate, they are thinking about it as a lifestyle decision (a beach house for family getaways and vacations) and as a financial/investment decision (positive cash flow from rental income, equity appreciation, etc.).

This article considers the financial implications of rental income-focused properties and lifestyle-oriented properties. I will suggest some things you might want to consider if you are thinking about this (or if it comes up in the future).

Let’s look first as these two scenarios and their respective financial implications.

The lifestyle option

This is a second home (or condo) that serves exclusively as a vacation home. It might be a beach house, mountain house, or lake house, or something anywhere you and your family like to vacation.

In this case, a vacation home is, first and foremost, a costly luxury consumption item, not an investment. However, many people who buy vacation homes plan to sell it at some point, perhaps after it has appreciated significantly. They can use the proceeds to buy a nicer vacation or retirement home, or for other purposes.

Financial implications

Because it is a second home, and depending on where it is and the cost, you can double (or more) all your housing-related expenses: mortgage (unless you pay cash), taxes, insurance (which can be much higher in coastal communities), maintenance (also higher around saltwater), furnishings, utilities, HOA fees, rental company management fees (if you also rent it and use one), etc.

There are, however, some tax benefits for second homes. According to the IRS, “mortgage interest paid on a second residence is deductible as long as you don’t rent out the residence during the tax year. The mortgage satisfies the same requirements for deductible interest as on a primary residence.” There are limits on how much of the debt qualifies based on when the house was purchased. Certain property taxes may also be deductible.

If your second home appreciates, you will probably have a tax liability when you sell it. Although a primary residence can qualify for a capital gains tax exclusion, the sale of a second home almost always presents a taxable event in the form of the capital gains tax (which for many will be lower than their regular income tax rate).

The investment property option

An investment property is a real estate property purchased as an alternative investment (to stocks and bonds, for example), for the primary purpose of generating passive income, capital (equity) appreciation, and tax benefits.

Financial implications

Real estate investors typically look for well-priced properties in high demand long-term-rental areas. Lease contracts provide stability of rental income, IRS rules permit depreciation and operating expense deductions, and there is always the possibility of capital appreciation. Actual cash-flow will depend on whether the property is mortgaged, management and HOA fees, maintenance expenses, occupancy rates, and rents in the area.

The potential financial benefits are a long-term passive income stream and capital appreciation. The main financial risks of rental properties are renter default, real estate cycles (usually tied to economic cycles), maintenance and repair costs, legal fees (for non-payment or if eviction is required), and renter demand.

The tax implications of rental real estate are too numerous and complex to go into here. Suffice it to say they are different than those for primary residences and second homes. The main areas of concern are how rental income is taxed and what taxes are due upon sale. (Refer to this IRS article on Real Estate Income Deductions and Recordkeeping.)

Mixing the two

I don’t have data to confirm it, but I suspect that this is the strategy that most people want to use who are thinking about a second home. Many people who buy a vacation home plan to rent it out for many weeks or months a year to defray the high cost of ownership.

But this is where things get tricky. Shared use is a reasonable strategy, but once you do, you are mixing the rental property (investment) decision with the vacation home (lifestyle) decision.

Financial implications

How things work out financially with a “mixed-use” strategy will depend on several factors: how much you use it, how often you rent it and at what price, and total operating costs.

For some people, buying a vacation property would be a waste of money—they simply won’t use the property enough to justify the costs. If you’re a busy working family, you’d spend a few weeks and a few weekends there each year, at most. Will the novelty wear off after a few visits or a few years? Then, the other 40-50 weeks of the year, you’ll be paying for it, unless you rent it out enough to cover your expenses.

On the other hand, if you want to use the house a lot as a vacation home (meaning less rental income), you may find it very difficult to get a positive cash flow or a quick return on your investment.

Statistics are hard to find, but according to a HomeAway report, in 2016, “nearly three-quarters (70 percent) of vacation rental owners are able to cover more than half of their mortgage through renting, and more than half (54 percent) cover three-quarters or more of their mortgage.” And that doesn’t include management or maintenance costs, which can be very high in some resort areas.

I think this is reasonably accurate for NC (the state I live in) coastal communities. The reason is that beach rentals in NC are seasonal. In areas farther south, the rental season is more year-round, but in NC, the peak rental period is limited by seasonal temperatures and tends to run from mid-May to mid-September (between 12 and 16 weeks). The majority of rentals, and the highest rents, occur during this time. Occupancy rates and rents during the “off-season” tend to be lower.

According to real estate expert Zillow, the “operating expenses related to vacation rentals are similar to those of a hotel — 60 percent to 75 percent of revenue.” Contrast that with the cost of a modest single-family home or condo rental that is in the 35-45% range. This is one of the big reasons many vacation rentals have a negative cash flow.

Some significant expenses that chip away at rental income are management fees and maintenance costs, which can be very high in coastal communities. Rental agencies provide valuable services such as finding renters, cleaning, and repairs and handling customer calls and complaints. However, in NC, the commission rate is in the 16-30% range. At 25%, the agency is taking a big chunk of your rental income. If you want to do it yourself, plan on spending a lot of time marketing, screening renters, handling contracts, resolving complaints, coordinating maintenance, etc.

The “mixed-use” second home also presents some unique tax implications. One is that a vacation home can only be treated 100% as an investment property if personal use is either 14 days or less, or 10 percent of the days the property is rented to others at fair market rent during the year. If you exceed those limits, the property is considered a second residence, and you must treat the rental portion of the vacation home separately from the personal part.

If the rental portion’s income doesn’t cover the costs, you may be able to take a taxable loss on Schedule E of your Federal Income Tax. The tax laws for rental properties as very complicated, so it’s best to talk to a tax accountant. There are distinctions between active (e.g., salary from a job) and passive (e.g., rental income) and between rental properties and personal residences. Each is a different tax situation.

For example, rental losses are always classified as “passive losses” for tax purposes. This limits your ability to deduct them because passive losses can only be used to offset passive income. Without passive income, your rental losses become suspended losses you can’t deduct until you have sufficient passive income in a future year or sell the property to an unrelated party. And this is just one small aspect of the tax law.

Questions, considerations, and sugggestions

I am not an anti-second home or rental property person. I don’t own any personally, but I have thought about it, especially since I am “retired” and could theoretically get more use out of a second home.

When I have looked at the numbers, I just couldn’t get comfortable with it. But then I am financially conservative.

You may be more inclined to take the plunge. So, apart from the things I’ve already mentioned, here are some things you might want to consider before you do:

Seek wise input and counsel.

It is always wise to counsel on major decisions such as buying a second home (Prov. 13:10). Talk to others who have done so. And especially, talk with financial and real estate professionals who can advise you based on your situation.

What is God’s will?

I don’t think there’s anything in the Bible that says that it is wrong to buy an investment property or a second home, or something that could function as both. 

In fact, I think a vacation home could be legitimately used for personal enjoyment, to bless others, to build memories and relationships, etc.

The question that every steward has to answer, however, is whether it’s wise and whether it’s God’s will for you and your money. Make that your priority and everything else will fall into place (Matt. 6:33).

Do you like to travel?

When you buy a vacation property, you are basically “married” to that property until you sell it. You will have a similar experience every time you stay there, with minor variations. If you enjoy the diversity and excitement that vacationing in different places affords, you may get bored with the vacation home very quickly.

Here’s an idea: Add up the annual cost of ownership, divide by the estimated days you’ll use the property over the years, and figure out where else you can go vacation with that type of money. God created a vast and beautiful world out there (Psalm 19:1)—you may get excited by the number and variety of vacation options available to you.

Will you use it enough?

This is related to the one above. Most working families average 2-4 weeks of vacation a year, excluding those who can work from home. If you can’t go on vacation for more than four weeks a year, you may be better off renting your vacations.

Pay cash if possible, or at least make a substantial down payment.

There are really only two ways to buy a second home. The ultra-conservative way (a la Dave Ramsey), whether you rent it or not, is to pay cash for it (Prov. 22:7). I think that view has merit but can be very difficult for most people, especially when it comes to expensive resort (beach, lake, or mountain) property.

An alternative view is that it’s all about leverage. The idea is to use other people’s money to buy an appreciating asset like a vacation home and use rental income to offset the costs.

If I were going to purchase one, I would probably be somewhere in the middle. If it were a relatively expensive property, I’d want to have a sizable down payment to keep my financing costs as low as possible. If not, I’d try to pay cash.

If you mortgage the property to the hilt, you are taking on some risk. If the rental market falters, you are stuck holding the bag. In the worst-case economic scenario, you could end up “under-water” as people did in 2008. You would need to have the financial resources to weather a storm like that.

Don’t buy at market peaks.

Resort rental property can tend to be the most volatile based on economic conditions and the most expensive. In general, real estate has been going up since the “great recession,” and I suspect beach properties in desirable locations have gone up even more so. On that basis, now may not be the best time to buy; better to wait for another real estate recession. That doesn’t mean there aren’t deals out there, but I suspect they are hard to find.

Buying a vacation property can be a wise long-term investment if you buy at the right time. But to profit from your investment, you must either make rental income or sell.

Count the cost.

Make sure you count all the costs—time and money (Luke 14:28). 

First are the time and energy you have to spend on it in addition to your primary residence. If you own a second home, many things have to be attended to, especially if you don’t want to spend the money to contract them out. And if you don’t hire someone to handle rentals, you’ll have to handle all rental-related activity and all the extra services to maintain the property.

There are also a lot of costs involved in addition to the mortgage. Insurance, taxes, and maintenance expenses call add up. You may also be paying HOA fees and property management fees if you hire someone to handle the rental side of things.

Do you really want to rent out your vacation home?

For some people, a vacation home is truly a “second home.” Make sure you are okay owning a nice vacation home and renting it out. Some people don’t like the fact that the house gets used and abused sometimes.

How long do you plan to own it?

According to the National Association of Realtors, the average vacation property owner only plans to own his/her home for seven or eight years. That’s not a long enough time to withstand a potentially wrongly timed purchase, substantial unexpected repair costs, costly upgrades, and a ridiculously high sales commission when you decide to sell it.

On the other hand, forever is a very long time. But if you don’t plan to own the property for at least 10 to 20 years, you may not want to bother.

Can you weather a storm?

I’m not talking about a hurricane (although that’s something to think about); I’m referring to an economic storm. During a major economic downturn, the vacation property market can get hit hard as people cut-back on non-essentials. As the owner of a property, you can’t “cut back” on the fixed costs of ownership (mortgage, taxes, insurance, fees, etc.).

Rental income is a great way to offset the ongoing cost of owning a vacation property during the many weeks of the year that you will likely not be there. But, as we all know, it is uncertain. Therefore, how much margin do you have in your monthly budget? Could you maintain a second home with negative cash flow for an extended time? If not, best to reconsider.

Can you imagine a scenario where you lose your job and a ton of equity at the same time, like what happened to so many during the 2008 recession? Not good! You will need margin in the form of multiple income streams or large cash reserves, and a financial backup plan, if you want to own a vacation property.

How is your net worth (and risk) apportioned?

If you’re even thinking about a vacation property, I assume you are in pretty good shape financially. But many people have most of their net worth in real estate (their primary residence). If you increase your exposure to the real estate market, you will take an even greater hit when it cycles down (which it invariably will).

When the 2008-2009 financial crisis hit, the average Americans saw their net worth getting wiped out because property accounted for 80%+ of their overall net worth.

Will owning a vacation home really make your life better?

How’s that for a finisher?

The decision to buy a second home is typically more of a lifestyle decision than a financial one. And many of the arguments for homeownership, vacation or otherwise, are more emotional than financial. Nobody needs a vacation home. It is a luxury that requires a lot of overhead—financial and otherwise—to purchase and maintain, whether you rent it out or not.

That said, there are some ways owning a vacation home can add to your life in positive ways: control of ownership, repeat vacations, the joy of sharing with family and friends, as a fixer-upper hobby, or an ideal retirement home in the future. (Be careful about that last one—circumstances and plans change over the years.) Whether those things are worth the cost is something only you can decide.

Final thoughts

I completely understand the allure of owning a personal vacation property. It comes down to a very personal decision. As for most real estate decisions, there is no simple rule of thumb for buying vacation properties. If you have to take out a large mortgage and rent it to make ends meet, the odds are stacked against you financially, but you may be able to make it work.

Lifestyle is important. But in my opinion, liquidity and investment capital are also very important, especially in retirement. Many retirees find themselves with most of their wealth tied up in property—house, furnishings, cars, and other “stuff.” Adding to that with a second home may be counter-productive.

But most important is the stewardship question. Each person needs to answer that in their own heart before God (Rom. 14:12; 1 Cor. 4:1-2). But please don’t think I am suggesting you don’t have the freedom to buy a second home if you think it’s a wise decision and believe it is God’s will for you and your family.