Should You Purchase That Second Home?

Physician's Money Digest, September15 2003, Volume 10, Issue 17

A doctor-friend recently asked me about theadvisability of buying a condominium inColorado. He was enamored with the ideaof having a permanent place to visit in thesummer and during ski season. He was tired of alwayslooking for a new place. "I was told that I could rent outthe condo for several hundred dollars a day when I'mnot using it," he said.

I began a series of questions and explanations. First,I asked if he and his spouse would really want to go backto the same place repeatedly several times a year, andthen for many years. If not, the purchase was not automaticallya good idea. If so, the additional considerationof the cost and time involved in returning to his newdream house was next on the agenda.

Some second homes are in locations so distant (perhapsthe allurement at first glance) that returning tothem on a regular basis becomes a chore and a significant expense. After clearing these hurdles, we continuedour exploration of the financial issues.

Finance Check List

The cost of desirable, easily rented second homesalmost always reflects the potential income. This meansthat not renting out the property is very expensive, andthat the income from such rentals is not a windfall, butappropriately compensatory for the inflated purchasecost. We discussed that the rental income is not certain,and that the cost of property management from far awaycould easily chew up half of the received income.Accordingly, I asked my friend to do a carefulanalysis of the following items:

  • Compare the costs of similar propertiesin the area.
  • Carefully inspect the property andanalyze the property's cost of maintenance and management,regardless of potential income.
  • Consider financing issues. How much money areyou prepared to put down and what's the size of themortgage? How would this affect your cash flow andability to invest for retirement?
  • Rethink the issues of cost and time spent travelingback to the same location repeatedly over the years.
  • Obtain a realistic appraisal of the potential capitalgain you would realize if you eventually sold thehome in future years.

Tax Issues Examined

There's also the tax treatment of a rental property toconsider. If my friend were to rent the home out less than15 days per year, he could keep that income withoutreporting it to the IRS. He could deduct only mortgageinterest and property taxes (if it's a second home and histotal home mortgage indebtedness on both propertieswas less than $1 million).

If he wanted to rent out the property for more than14 days a year, but also use it more than the sameamount of time, then he'd have to split the maintenanceand depreciation expenses proportionally between thetime allotted to personal use. This seemed the mostlikely scenario for my friend.

If he decided at some point to use the house personallyless than 15 days a year or less than 10% ofthe days rented, then he could treat the house as abusiness. This means he could deduct all repairs,maintenance, depreciation, interest, and propertytaxes against the rental income. But he wouldn't beable to declare a loss unless his adjusted grossincome was less than $150,000 a year.

If he planned to use the house as a businessupfront, he should be especially careful about the plusesand minuses of the purchase, and minimize the pluses ofoccasionally using the property. I referred him to IRSpublication 527 (www.irs.gov/pub/irs-pdf/p527.pdf).

By the time we finished our talk, the fire had goneout of my friend's eyes. Feeling sorry that I had potentiallypunctured his balloon of enthusiasm for a secondhome, I mentioned that he could consider an equity sharingor more traditional time-sharing arrangement atmuch less cost and risk.

Steven Podnos is a practicing internist and fee-onlyfinancial planner in east-central Florida.He recently passed the Certified FinancialPlannerâ„¢ practitioner boards and invites questionsor comments at stevenp302@aol.com.