If your plans for retirement include spending extended periods in your favorite vacation spot, you might be tempted to forgo hotel rooms and VRBO properties and buy a second home instead. But is a vacation home really a good investment in retirement? Like most investments, the benefits of owning a second home depend on your personal financial situation and your goals for retirement, but here are some pros and cons to consider:

The Pros

A vacation home can help you diversify your assets. People often include property in their portfolios, and some consider it a good hedge against market volatility. However, increasing mortgage rates, coupled with higher home prices, could make a second home an expensive investment right now.

A second home could provide income. The IRS has specific rules regarding residential rental property, including how to allocate expenses, depreciate the home’s value, and handle special situations.

If you rent property that you also use as your home and you rent it for fewer than 15 days during the tax year, you don’t have to include the rent you receive as income, and any expenses related to this activity are not considered rental expenses.

Different rules apply if you have a vacation home that you rent. You must divide your expenses between rental and personal use, and the number of expenses you can deduct may be limited if you consider the dwelling your home. In addition, the IRS requires that you ask a “fair rental price,” which is generally the amount a non-relative would be willing to pay. Your tax advisor can help you understand and apply the IRS rules to your rental situation.

Your vacation home can provide a legacy for your heirs. Family vacation homes can be great places to create memories and traditions for children and grandchildren. If your children can see themselves continuing to use the home after you’re gone, they may be interested in owning and maintaining it in the future. As Savant advisor Jeff Lewis wrote in 2021, many different options exist for keeping property in the family. Your advisor can recommend which option or options may be best for your situation.

The Cons

Getting a loan may be difficult. If you are already retired, you may have more difficulty securing a mortgage than you did when you were working. It’s not impossible, however, according to lender Rocket Mortgage. If you can demonstrate that you have a dependable and predictable income, which could include Social Security, pensions, spousal or survivor benefits, retirement accounts, or other income, you may still qualify.

Loans for second homes require higher down payments and often come with higher interest rates. When purchasing a home with a mortgage, lenders usually require a down payment. On a conventional loan for a second home, expect to pay at least 10% down, depending on the lender. You can also expect to pay a slightly higher interest rate than you would for a primary residence. According to Bankrate.com, some lenders may also have stricter cash reserve policies and requirements for debt-to-income ratios.

Rental income is not a guarantee. While gaining passive income from renting your second home is a benefit, it may require you to be an “active” landlord. Be prepared to handle damage, theft, emergency calls in the middle of the night, and costs for ongoing maintenance and repairs. At the very least, be prepared to hire a property management company that will handle this when you are not there. Also, keep in mind that if you plan to both use and rent the property, you are most likely to use the property during prime renting season. Think Arizona or Florida in January, February, March, and April. If you’re using it, you may struggle to rent it during prime renting season. This could reduce the total amount of rental income you receive when thinking about a second property for cash flow purposes.

Capital gains taxes are different for second homes. The IRS treats second homes, including vacation homes and investment properties, as capital assets. That means you can’t exclude capital gains unless you pass both ownership and use tests for your property. You can minimize the capital gains tax when you sell your second home. This article by SmartAsset reviews a few options, but you should consult your advisor for specific recommendations.

While this list of pros and cons is not exhaustive, it can give you a flavor of what to expect when you purchase a vacation home in retirement. Before you begin searching for a second home, think first about how the purchase fits in with your financial goals. Then, talk to your financial or tax advisor about your best options before you sign on the dotted line. Buying a vacation getaway in retirement can be a great choice, but only if you can minimize the potential headaches.

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