But decide if you'll use it or rent it out

Sunday, July 30, 2006

By Julie Tripp

Baby boomers are fueling the vacation home market, turning to real estate as a great alternative to more volatile stock holdings as they near retirement.

In some prime second-home spots, they're getting double-digit property appreciation for their money -- and more. Not only can they enjoy their investments by relaxing in a cottage or condo, they can qualify for some healthy tax benefits, too.

No wonder 70 percent of vacation home owners who responded to a January survey by the National Association of Realtors said that buying their property was a better investment than stocks.

Three-fourths of vacation home owners bought their homes for personal use and don't rent them out, according to the survey. Of the 25 percent that do rent out, the median is 12 days.

Whether to use your property as a rental or for yourself is an important decision when it comes to getting a mortgage and claiming tax deductions on vacation property. If the home is used by you and not rented out for more than 14 days a year, you can get good rates and terms on your mortgage; deduct the vacation property's mortgage interest and taxes from your income; and pocket up to two weeks' rental income without reporting it on your 1040.

About a third of vacation-home owners in the survey paid cash for their property, but the rest of us have to borrow unless we're lucky enough to inherit the family cottage.

Lenders generally regard second homes the same as first homes, assuming you're planning to occupy the property at least part of the time and manage it yourself. Some require the second home to be at least 50 miles from your main home. You'll get the same interest rate, down payment requirements, loan fees and terms.

Last week, that translated to a 30-year fixed-loan interest rate of 6.87 percent with 20 percent down and a half-point fee -- 0.5 percent of the loan amount paid upfront -- at Wells Fargo Home Mortgage.

The Internal Revenue Service allows taxpayers to claim deductions for mortgage interest and property taxes for two primary personal residences. The IRS is even amenable to allowing deductions for "residences" that are sailboats or motor homes if they have toilets, cooking facilities and sleeping quarters.

If you have a main home, a beach house and a yacht -- can we come visit? -- you can get the benefit of three interest deductions by borrowing extra from your home equity and paying cash for the boat. That way, you can claim all the interest without exceeding the rule on two primary residences.

If you're buying a home with friends or relatives as partners, you can get a loan for that, too. The lender will pool both incomes to qualify the borrowers for the hefty payments often needed in today's high-priced second-home market.

What if you want to use your house personally and rent it out? You can still get a regular home mortgage for a vacation home that you rent out more than 14 days. Lenders are most concerned about full-time rentals and probably won't send out the rental police to check up on you. But some institutions may ask you to sign a document stating your intentions about owner and non-owner occupation when your loan closes.

If your intent is to continually rent the place, you'll need a mortgage from the "non-owner occupied" investment property category. You're likely to get the same interest rate as on a residential mortgage, but you'll pay more in points. The difference on a $200,000 mortgage at Wells Fargo is 1 point: a $1,000 fee for the personal residential loan and $3,000 for the investment property mortgage.

Investment property owners also may be required to put more money down and pay more to insure the home, because lenders view a property occupied by a series of transient tenants as a bigger risk.

The advantage of using the property as an investment rental is considerable at tax time, says Michael Larson, a Lake Oswego , Ore. , certified public accountant. You can deduct the full cost of utilities, maintenance, insurance and depreciation as well as the mortgage interest and taxes. You can deduct expenses beyond the rental income you report and against your regular income, up to $25,000. (The allowance phases out between $100,000 and $150,000 in annual income.)

On the downside, "You'll have big-time wear-and-tear on your property," Larson says. And you could lose that $25,000 allowance if you use the place yourself for more than two weeks.

If your use of the vacation property falls between all personal and all business, there's a solution for you, too. But you've got to keep good records.

If you stay at the vacation home more than 14 days (or more than 10 percent of the days you rent it out, whichever is greater), you must report the rental income and allocate expenses between personal and business use. Keep a log of your income and expenses. Note who stayed, when, what work they did if it was you and your family, and what rent they paid if it was a tenant, suggests Jim Gallucci, a certified public accountant in Portland , Ore.

Jot down notes about the work you do because those work-party days won't count against the 14 days you can stay there and still retain your rental tax treatment, he says.

If it's a second-home lot or acreage you want to buy, several lenders offer lot loans, but they expect you to build within one or two years. A home equity loan could be a better way to go because you can deduct the interest and hold the property as long as you like. If the lot is adjacent to your vacation place, and your intent is to landscape it or use it to preserve your view, for example, you can claim the deductions on that property the same as on the home, Larson says.

Each case is different and lending policies and tax law can be tricky, so check your details with your lender and tax adviser. Choose to keep your vacation place all to yourself, rent it out or do a little of both, knowing you can always change your strategy for the next tax year if you want.