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Practice Management

Vacation homes are more affordable now, but clients should recognize the ongoing costs and the need for an exit strategy.

Clients who resisted the lure of a vacation home when prices were spiraling higher may feel a pressing need to buy now. Second-home prices have plunged and historically low mortgage rates reinforce the idea that this is the time to grab a dream beach house or mountain cabin.

The opportunity is just that appealing for Lon Morton, who heads a wealth management firm in Calabasas, California. He's in the process of buying a place near Palm Springs. "If you want it and can afford it, you can take the attitude that you're saving a bundle from what you would have paid a few years ago," he says.

Long-term investment prospects may be favorable. "There are a lot of properties available in attractive vacation areas because many people are trying to unload their second homes," says Lori Embrey, a principal at Fairfield Investments and Wealth Management in Pickerington, Ohio.

Remembering that the three rules of real estate are location, location, location, today's low prices also could have downside protection. "The baby-boomer generation is starting to retire," Morton says. "That demand might create a floor for second-home prices, preventing a free fall."

According to the National Association of Realtors' 2011 Investment and Vacation Home Buyers Survey, there are 7.9 million vacation homes in the United States, compared with 74.8 million owner-occupied homes. The median income of vacation-home buyers in 2010 was $99,500. Those buyers paid a median price of $150,000, down 11.2% percent from 2009, while the median primary residence price declined only 4.5% from 2009 to 2010.

Think Twice
Potentially saving a bundle on the purchase price is not the only second-home issue planners should discuss with clients. Practical and personal issues are vital, as well.

"Many people say they feel obligated to use their second home during their vacation time," notes Tom Orecchio, a principal at Modera Wealth Management in Westwood, New Jersey. "Because they are paying for it, they cannot justify going elsewhere."

That means the buyer of a second home needs to be eager to go to the same location time and again. As Ross Levin, president of Accredited Investors in Edina, Minnesota, puts it: "This is a good time to buy a second home if you view any home purchase as a used asset and don't care about the long-term investment aspects of the property."

"A second home is a luxury, not an investment," adds John Eckel, founder of Pinnacle Investment Management in Simsbury, Connecticut. "If clients express interest in buying one, I try to make the point, over and over, that they should make sure all of the essentials—retirement, children's education—are taken care of first."

In addition, although second homes may be available at bargain prices, buying them now might not be so simple. "Many of the people who most need to sell because of their own financial hardship would love to... but can't because they're upside down," Embrey says, meaning they owe more on their mortgage than the home is worth. A seller who owes more than a sale will generate must make up the shortfall, or obtain the lender's agreement to close the deal in a short sale, and that approval may not be granted. "Patience may pay off handsomely if you have the intestinal fortitude to wait out a short sale," he says.

Borrowing Trouble
Financing a second home also might be a problem. "I have a client who recently retired debt-free with excellent credit and ample liquid assets," Embrey says. "This client does some occasional consulting and photography work to make a little money, so he didn't need to set up regular IRA distributions to replace his monthly income." Nonetheless, his loan applications were rejected.

Lenders typically want to see regular income from distributions for 12 months, Embrey explains. His client wound up using a home-equity line of credit to finance the second home. At the same time this client was denied a mortgage, another of Embrey's clients—one with no savings and negative home equity—had no problem getting a loan because he has a large pension.

Even for those who are approved, a second-home mortgage might be surprisingly costly. "Most people aren't aware that mortgage rates are higher for second homes than for primary residences," Embrey says. The risk is higher that buyers will stop making payments if they suffer from financial hardship, so lenders impose a higher rate.

Before moving forward, planners of potential second-homebuyers should estimate the total carrying costs, Orecchio says, such as property taxes, utilities, maintenance, association fees, insurance and security. Additional expenses may also include boats, bikes, etc., as well as another car.

Levin suggests a client considering a second home add all the projected annual costs and divide by the number of days the place might be used. "If you don't mind bringing your clothes with you, you can generally rent a suite at the Ritz for less money," he says.

Tax Topics
As is always the case with a major financial decision, there are taxes to consider. "Clients often have the misperception that a vacation home is a large tax write-off," says Ed Kohlhepp, a financial planner in Doylestown, Pennsylvania. "They're totally misinformed."

Nonetheless, just like with a primary residence, second-home owners generally can deduct property taxes (if they don't owe the alternative minimum tax) and mortgage interest (up to $1 million of total home acquisition debt). Other deductions might be available to clients willing to rent a second home to paying customers. A rental of up to 14 days a year will be income tax-free, although no related deductions are allowed. This tax break also applies to a 14-day rental of a primary residence, which generally gets better tax treatment than a vacation home.

On the other hand, when you sell a second home, you'll likely be subject to capital gains taxes. "There is no $250,000 or $500,000 tax exemption, which is available on a sale of your primary residence," Embrey says. The "tails you lose" aspect of selling a vacation home is the same as for a principal residence: sellers get no tax benefit if they take a loss.

Time to Sell
"As with all residential real estate now, you may be sitting on a second home for a while unless you price it attractively," Orecchio says. "Clients should consider their goals for the property and whether those goals have changed. If they've changed, it is probably time to sell."

While the sales environment is terrible in most locations, eliminating the carrying costs could make it worthwhile to accept a lower price. "If you are holding simply to wait until prices rebound, you could be holding for a long time," Orecchio says. He suggests doing a calculation of carrying costs versus a reduced sale price to determine how long you'd have to hold on before the carrying costs outstrip a reduction in price.

Levin agrees that clients who wish to sell but can't get a desirable offer should estimate the cost of waiting. "They should calculate the time value of money on the equity and all carrying costs," he says. "They will be shocked at how much the home would need to increase in value each year in order to justify not taking a lower price than they were hoping to collect."

Beyond financial motivations, disillusionment may result in a desire to sell. "A lot of our clients have been evaluating their second-home experiences," says Charlie Jordan, a wealth advisor at Brightworth in Atlanta. "They're asking, 'Is this what I thought it would be?' "

Often, the answer is no. "Some clients are not using the home as much as they expected, and their children are busy with their own families," Jordan says.

"There may be some of those big wonderful moments that clients dreamed about, but not as many as they had hoped for. Once we worked through the numbers with them, several clients put their second homes up for sale. That's especially true for clients who have a mortgage on the home and who are not receiving any rental income from it. Some have sold their second homes, usually by dropping their asking price by an amount equal to what they would have paid to keep the home a while longer," Jordan adds.

Unhappy Afterlife
Although selling a second home might bring a disappointing price today, not selling the home can deliver unexpected problems after an owner's death. Levin uses the word "nightmare" to describe the possible results of keeping a second home in the family, and several planners offered stories of family discord over a vacation home given or bequeathed to the next generation.

Orecchio, for instance, tells of a beach house owned by two brothers whose families split the use of the home. "The brothers have since died, and their halves of the home are owned by multiple cousins."

No family picnic is scheduled. "Some of the new owners on both sides want to sell the property because they need the money and don't use the property as much as they used to," Orecchio says. "The other new owners don't want to sell, but they can't afford to buy out the ones who do. One owner has decided to sue the others to block a sale."

Consequently, all sides are incurring legal fees. "It's a big mess, with lots of stress and hard feelings about getting lawyers involved."

For siblings as well as cousins, co-owning a vacation home received via gift or inheritance can be difficult. What is the best way to avoid disputes?

A first step is a discussion about the home's future, perhaps initiated by a financial planner. "Clients usually don't give much thought as to how a vacation home will be handled after their death," Kohlhepp says. When the topic arises, they may be reluctant to concede that their children could fight over a vacation home the family has used for years.

Happy memories often get in the way of the most practical solution: selling a home when the owners cut back their use of the place and leaving the cash to the next generation. "Most people need to reconcile when to sell their second home," Levin says. "If a second home is closer to home, it might be a more emotional decision. The memories may be strong."

Clients opposed emotionally to selling a beloved home might be persuaded to consider a sale after their death. "One strategy might be to leave it to the estate, which can sell it," Eckel says. Then the cash can be distributed to intended heirs.

If clients are determined to keep a second home in the family and more than one new owner will be named, sophisticated planning may be necessary to avoid disagreements. Orecchio suggests having a written contract and including that agreement in the current owners' estate plan. "We have talked about setting a voting standard where majority rules, along with clauses that would provide for a buyout if owners in the minority wish to sell," he says.

Levin says that passing a vacation home to the next generation works best if a trust is set up to fund future operating costs. Jordan concurs that entity ownership may be desirable and adds that a provision for adequate seed capital is often necessary to assure that a property remains in the family once it passes to younger owners.

Embrey has seen a second home owned by a limited liability company. "Then the LLC is owned by a trust or trusts," she says.

"The LLC document allows for direction as to how the property will be used and maintained and who will pay those expenses. That's helpful if a client owns a family heirloom and a number of people or families are involved in the estate plan for the house." If financial planners get involved in discussing the outlook for a client's second home, problems may be averted for current as well as future generations.


Donald Jay Korn is senior editor of Financial Planning.

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