Are you dreaming of a mountain cabin or an oceanfront bungalow hideaway? Then you may want to consider that a vacation home can offer some tax savings. Whether you choose to use the home solely for enjoyment or combine business and pleasure by renting the property part-time, it is important to understand the tax laws for a second home.
Tax Laws for Second Homes
Click here to view a brief but powerful guide on the tax benefits relating to vacation homes as personal residences or rental properties.
Vacation Home Investment Resources
Booking a Vacation Property
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Pricing Strategies For Vacation Homes
This comprehensive Rental Income Calculator helps you determine if the revenue you’re receiving from your rental property offsets the additional costs, risk, and hassle associated with self-management.
Investment Tools for Vacation Homes
Capitalization Rate for Investment Home
There are a couple of tools (financial formulas) that can help facilitate smarter financial decision-making in the context of real estate. The first is the Capitalization Rate, often referred to as the “Cap Rate”. According to Investopedia, the Cap Rate is the rate of return that an investment property will generate based on its current market value. It’s a quick way to compare different investment properties you are thinking about investing in. To calculate the Cap Rate, use the following formula:
Expected Annual Net Profit ÷ Current Market Value of the Property
Note: Be sure to use the current market value of the property and not the original purchase value in your calculation.
Example:
Let’s say you are considering buying one of two rental properties.
| PROPERTY A | PROPERTY B | |
| Current Market Value of the Property: | $1.2 million | $1.9 million |
| Expected Annual Net Profit (annual income after expenses): | $120,000 | $175,000 |
| Cap Rate: | 10% | 9.21% |
So what does this tell us? The chart above illustrates, if you purchase Property A, that you can expect to earn 10% per year after expenses, and 9.21% per year after expenses if you purchase Property B. All other factors being equal, an investor will choose the property with the highest cap rate (Property A).
However, real estate market values are not stagnant and appreciation in a property’s market value can have serious implications for the cap rate. For example, if the market value of Property A rises by 20% to $1.44 million and the income that the property generates (after expenses) stays the same, the cap rate will drop to 8.33%. Therefore, it is important to consider potential rises in property values over time—which is a good thing—and the possibility you may have to increase rental rates over time to maintain a targeted cap rate.
Internal Rate of Return for Vacation Homes
The second tool is the Internal Rate of Return (IRR). IRR represents the average annual return of an investment property over its lifetime. Unlike the cap rate, which takes a snapshot of net profit in a given period, IRR examines projected cash flow (whether positive or negative) over multiple periods.
Calculating IRR is not for the faint of heart and can be intimidating to the average investor. The good news is there are a number of calculators and software packages out there that make the process simple, if you know how to use them. Keeping that in mind—and your time—let’s just cover the basic components you will need to know about to calculate IRR:
- Initial investment amount – what is the original lump-sum amount you invested in the property?
- Frequency of incoming/outgoing cash (cash flow) – weekly, monthly, annual, etc?
- The cash flow amount per interval – how much cash is coming in or going out during each weekly, monthly, annual or other interval?
- Discount rate (Borrowing cost) – what is the cost of the capital (interest rate) you will incur to purchase the property?
The investment property with the highest IRR is the preferred option. Also, consider the following factors:
1. Is the IRR positive or negative? Negative IRR indicates the sum of post-investment cash flows is less than the initial investment. Put another way, all of the cash flows generated by the property (over a specified period of time) add up to a value that is less than the original lump-sum investment in the property. The investment loses money at the rate of the negative IRR.
- If your primary objective is to passively produce a certain level of income from your investment property on a periodic basis, irregardless of your initial investment, you may not mind that the IRR is negative.
- However, if your main objective is to recoup your initial investment and generate a profit, positive IRR is quintessential.
2. “Return”-focused investors should seek an IRR that is greater or equal to the cost of capital (borrowing costs).
- If the IRR—even if positive—does not exceed borrowing costs, the investor is not fully breaking even on their real estate investment.
For more information, check out our blog: Mortgage Rate Spike.
Vacation Home as an Investment Conclusion
- In conclusion, view this PDF to learn more about the tax laws and potential savings surrounding vacation home ownership.
- Visit Airbnb, HomeAway, Wimdu, or Booking.com to promote your vacation home. Gain powerful insights by using Rented.com’s Rental Income Calculator.
- The cap rate is great for quick investment property comparisons.
- IRR gives you a clearer picture of the kind of returns the investment property will generate from start to finish.
- The higher the cap rate or IRR, the more desirable it is to make the investment.