VACATION PROPERTY

May 2006

What Ever Happened to Shelley Long – who appeared in a movie called "Money Pit" starring Tom Hanks and was produced by Steven Spielberg?

Articles abound that the real estate boom is over. Over the past decade, prices for vacation properties have accelerated at a far greater pace than primary residence areas. Vacation and investment properties now account for nearly 40% of properties purchased in 2005.  Vacation properties demand has accelerated because a second home has become a must have such as a color TV, a second car, a home computer, and internet access.

But vacation properties frequently turn into a money pit. A substantial percentage of traditional real estate returns come from current cash flow. A vacation property is the opposite, depending on capital appreciation to justify the investment. Rental rates have not kept pace with the increase in purchase prices.  Vacation properties typically incur negative cash flow of 5% on an annual basis even with full rentals. The combination of slow growth in rentals, overbuilding and rising interest rates, and zero appreciation for a few years is a real possibility. If you are depending on appreciation, you can see how a few flat years could result in a rush to the exits? The impact of a decline will however be felt most by speculators, not long time investors. Even the most pessimistic economists will acknowledge exclusive vacation properties will continue to command an increasing price.

But how can you overcome negative cash flow and possibly flat prices to afford your dream second home? The answer is the tax code. The tax code while complicated is a smorgasbord of benefits at every turn and for every income level for vacation properties.  First, for those not renting their properties, you can deduct interest and real estate taxes, assuming mortgage indebtedness on your primary and second residence does not exceed $1.1 million. As well, you may rent your property for 14 days annually to help defray your costs and not have to report the income, one of the few chances to receive income and not have to pay taxes.

If you rent your property, the tax law is complicated when it comes to your ability to deduct a loss. There are rules regarding the numbers of days used for personal purposes and as well as limitations regarding deduction of losses and income levels. The rules described above are long and boring but they are flexible enough that everyone will be able to deduct some sort of loss from the rental of your vacation property. Your cash flow losses are however supplemented by the benefits of depreciation. In the first five years, you can deduct 5-6 % of the purchase price of the home and 2% thereafter.

Finally, clients become frozen because they cannot decide on what home will be their dream home. Again, the tax law is your friend.  If you purchase a home and use it as rental or solely as a second home, and you want to buy a different home upon retirement, you can do a nontaxable exchange of the proceeds of your old vacation property into your new home wherever it may be. The tax benefits of a nontaxable exchange give you a high motivation to purchase a vacation property, even if it is not your dream home, sooner rather than later.

Vacations homes are a significant commitment of resources but can provide for a long term tax advantaged investment. A short term decline in prices caused by the fall out of over building and excessive purchases may be an opportunity to buy. 

Call Diane Burke at Cover & Rossiter (302) 656-6632 or e-mail at Dburke@coverrossiter.com for more information.