Thinking of a Second Home? Here Are Some Key Considerations
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For many individuals and families, owning a second home is a common goal. Some are enticed by the idea of another “home base” where they can escape to and enjoy a different lifestyle. Some view it as their future primary residence before and after retirement. Others are enticed by the potential financial benefits of owning a second property, such as rental income and home appreciation. Often, the clients I work with are interested in a mix of these benefits, such as the executive that wants to purchase a house in Tahoe for vacations with the family, while also renting it out in the offseason.
The way I generally view these decisions is through the lens of opportunity cost. What is required, in terms of money, time and energy, to own this second property? How else could those resources be put to work? In light of that comparison, is the prospect of owning a second home still attractive and exciting?
I’m hoping to purchase a secondary residence. How do I begin to think about that?
I advise clients to start with the “why”. What is the goal of this home purchase? What is the purpose of the property? Is it purely for enjoyment or do you see this as a place to which you could eventually move or even retire? Also, I suggest clients consider, realistically, how much you will actually use the property. Yes, Tahoe is beautiful. But, will you really go there every weekend? Or, if realistically you will go less often, does purchasing a home make sense as opposed to staying in a hotel or resort or renting for a weekend, week or for a season?
It’s important to understand the cash flow implications of a second property. In a state like California, the added costs can be considerable. Does this added expense leave you room to do other things in your life that bring you meaning? Can you still take the vacations that you love? Or, will you still be able to contribute meaningfully to your other goals?
As for taxes, if you plan to use the property and also rent it, there are specific rules that determine whether rental income from the property is taxed or not. For example, if you rent the property for 14 days or less a year, you won’t need to report the rental income. People who own properties abutting the Augusta National Golf Club, for example, can rent out their houses for substantial sums without any tax liability during the Masters Tournament, since the tournament is less than 14 days. Lucky them! If they were to rent for 15 days, that tax benefit would no longer apply. The upshot for tax? Details matter. For more reading on that topic, here’s a great primer from Investopedia.
My plan is to purchase a second home primarily as a rental property. What should I be considering?
Above all, be realistic! Can you actually rent the property? Look into the local rules. Sometimes properties are ineligible for short-term rental due to neighborhood or association restrictions. Assuming you can rent the property, either short-term or long-term, is there the demand to actually do so? It is not uncommon for people to overestimate the amount of rental income that they will receive. It’s also advisable to allow for potential gaps in the rental calendar. As you do your cash flow analysis, I recommend being conservative in estimating rental income so as to not put yourself in an untenable situation.
In terms of cash flow, there are several factors to consider. Unless you live around the corner, you will likely need to hire a property manager, for whom a 10% fee on the rent is commonplace. And remember all the other recurring home-owning expenses, such as property tax, mortgage payments and insurance. From a tax perspective, mortgage interest on a rental property, or a portion of it, is deductible against rental income, as is maintenance and homeowners insurance. Here and here are some good resources on potential tax breaks from a second home.
With rental properties, I recommend looking at the whole picture. A key question is: what is the ratio between the net operating income produced by the property and its current market value? This is often referred to as the capitalization rate. Say you have a million dollar home producing $50,000 of net operating income per year. That is a 5% capitalization rate. Pure real estate investors often seek a 10% capitalization rate or above. (However, if the property also serves you for personal enjoyment from time to time, you may settle for less.)
Let’s say you are going for a pure investment property worth two million dollars in the Bay Area and are seeking a 10% capitalization rate. Do you think you could rent it for $200,000 per year? That is likely tough. What is the opportunity cost of tying up that capital in a rental property, as opposed to say the stock market? Making those comparisons is important, especially if the goal of the property is mostly financial.
How would you recommend thinking about a second home from an emotional standpoint?
To many, the home is the foundation from which a sturdy and meaningful life is built. If you are seeking a second home to deepen your enjoyment in life, that is a wonderful and admirable goal. However, owning a second home comes with an inevitable toll on your resources (time, money and energy). Make sure the trade-off is worth it.
If the second home is being considered more as an investment, remember that as with any investment, your financial success is not guaranteed. Make sure that, even if things don’t go the way you want financially, you still have the resources to continue building a life of meaning and enjoyment.
The information provided in this commentary is intended to be informative and not intended to be advice relative to any investment or portfolio offered through Wealth Architects. The views expressed in this commentary reflect the opinion of the author based on data available as of the date this article [essay] was written and is subject to change without notice. This commentary is not a complete analysis of any sector, industry or security. Individual investors should consult with their financial advisor before implementing changes in their portfolio based on opinions expressed. The information provided in this commentary is not a solicitation for the investment management or other services offered by Wealth Architects. References incorporated into the report [essay] from third party sources are as of the date specified and are believed to be reliable. Wealth Architects is not responsible for errors in the third party data.