Purchasing a second home is a common goal often heard from clients during the financial planning process. From a winter retreat in retirement to a house renovation/flip, there are many reasons an investment property could be on your radar. While you do not have to be ultra-wealthy to pull off a second home purchase, it is critical to have a game-plan and the financial awareness to sidestep the many pitfalls that could get in your way.
So is it the right time to invest?
While interest rates remain low (3.76 percent for 30 year, 2.98 percent for 15 year mortgage Freddie Mac Primary Mortgage Market Survey), real estate prices have been steadily increasing since the end of the financial crisis. As a result, housing affordability has been declining, making it more difficult to identify attractive deals for investors. The relationship between home values and income is an important one as it suggests that buyers be more selective when preparing to make such a significant financial move. While the low lying fruit may be picked over a bit, there may still be opportunities for investors willing to do the research.
Once you have identified if an attractive investment opportunity exists, next you must determine if you are in the financial position to seize it. Consider carefully reviewing your financial plan to ensure you are on track for other important financial goals including sufficient emergency reserves, available cash flow, retirement funds, education funds, life insurance, etc. prior to making the purchase. In other words, be sure that you are on-track for your primary financial goals as you do not want to allow a second home purchase to derail the achievement of what is most important to you and your family.
Next, carefully review mortgage rules. As you can imagine, qualifying for a second home can be more difficult but certainly not impossible. It is important to note that a second home and an investment property will be treated differently when it comes to financing. While down payment requirements and mortgage rates will generally be the same for a second home, investment properties are treated a bit different. According to John Kussmaul, Mortgage Loan Officer for TD Bank in Freehold, NJ, “An investment property will require a minimum of a 20% down payment and rates are ½ percent higher than primary residence rates. Generally, the more you put as down payment the lower the rate.” Keep in mind, sufficient cash reserves and a strong credit rating will help with the approval process.
Identify the purpose
Are you planning to purchase a second home as a rental, vacation property or simply to renovate for a quick sale? It is important to clearly identify your purpose as it will impact the financial analysis when determining whether to move forward. For example, an evaluation of a rental property will be focused more on after-tax cash flow while a vacation home will be based upon affordability and the enjoyment it brings to your family.
Taxes - Vacation vs. Income Property
Taxes will have a significant impact on the viability of your purchase and it is important to have a handle on the different rules associated with a second home. Do you plan to use your investment solely for personal enjoyment? If so, you may receive a tax deduction on mortgage interest and property taxes. Renting out the property for greater than 14 days will result in an IRS requirement that income be reported along with deductions for rental expenses. The amount of time that a property is used for personal use versus rental use will impact the allocation of deductible expenses so be sure to review your plan with your accountant.
The popularity of television shows such as Flip or Flop or Flip this House has once again brought attention to the seemingly quick profits available to be made. Sure, house flipping may be profitable under the right scenarios. However, it is important to understand a few key variables. First, be sure to have a clear understanding of short-term capital gains as they can greatly reduce the attractiveness of a quick house flip. Whether you are talking about a stock or a piece of real estate, selling an asset held for less than one year will subject your potential profit to short-term capital gains rates which are taxed at ordinary income. This critical detail is often left out of the Hollywood house flipping shows. For example, they highlight a profit of $45,000 but fail to mention that they are going to have to pay nearly 40 percent of it to taxes. Remember, ask yourself if the risk you are taking is worth it in after-tax terms. Next, pay close attention to carrying costs. While flippers may have every intention to renovate for a quick sale, unexpected renovation issues and difficulty selling the property could lead to delays. The longer you have to pay the mortgage, real estate and insurance costs on a house flip, the less profit you may realize.
Review worst-case scenarios
It is important to build in safeguards in order to protect your financial position from the inevitable issues that may arise. First, be sure not to over-extend yourself. Just because a mortgage company approves the purchase of second home doesn’t mean you can really afford to buy it. Consider reviewing worst case scenarios including a decline in value, lower rental income, higher expenses/carrying costs and even a loss/decline in your personal income. Always be sure to plan your escape route in advance should your financial position change.
Purchasing a second home can be a rewarding but it is important to do your homework. Identifying your goals, safeguarding your financial position and making conservative investment assumptions can help ensure that a purchase is congruent with your financial plan. Since everyone’s situation is unique, consider speaking to your financial and tax advisers to determine the appropriate plan for you.
Kurt J. Rossi, MBA is a CERTIFIED FINANCIAL PLANNERtm Practitioner & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com, www.Independentwm.com and www.bringyourfinancestolife.com. LPL Financial Member FINRA/SIPC.