Q. We’re thinking about buying a house at the shore. Home prices are still pretty low while rental costs are very high, and if we rent it out for most of the summer, we think we can cover most of the expenses. What are we not thinking of?
A. Using a second home as a rental home has many implications beyond the straightforward question of whether or not the rental income will cover expenses.
But the potential rental income is the first thing you need to calculate.
“You can figure this out by researching what other similar properties in the area are generating in rental income,” said Michael Green, a certified financial planner with Wechter Feldman Wealth Management in Parsippany.
Next, he said, you will need to calculate how much your mortgage payment and other expenses will be each month.
There are two types of expenses to consider: fixed and variable.
“Fixed expenses are those that are regular and recurring, such as property taxes, insurance, association fees, if any, and the cost of a management and/or rental company, if you choose to hire one,” he said. “Variable expenses include fixing the air conditioner or heating, replacing the water heater, repairs to the roof and siding, flooring, fencing, or plumbing.”
Another major factor to consider is whether or not you will get all the income you expect, Green said. That means you need an emergency fund, enough that will help with cash flow if you don’t get the rental income you expect.
And yes, there are times when you won’t get the income you expect, or there could be other troubles with renters, and that could lead to legal fees.
“If a renter does not pay the rent, needs to be evicted, or causes serious damage to the property, you will incur the cost of an attorney,” Green said. “A property management company acting as an intermediary can help reduce the above risks, but not eliminate them completely.”
Then you need to consider the tax implications, said Michael Gibney, a certified financial planner with Highland Financial in Riverdale.
The tax treatment of the home is different depending on whether you use the home as a rental or as a second home.
From the IRS web site:
If you receive rental income for the use of a dwelling unit, such as a house or an apartment, you may deduct certain expenses. These expenses, which may include mortgage interest, real estate taxes, casualty losses, maintenance, utilities, insurance, and depreciation, will reduce the amount of rental income that is subject to tax.
If you rent a dwelling unit to others that you also use as a personal residence, limitations may apply to the rental expenses you can deduct. You are considered to use a dwelling unit as a personal residence if you use it for personal purposes during the tax year for more than the greater of:
1. 14 days, or
2. 10% of the total days you rent it to others at a fair rental price.
If you use the dwelling unit for both rental and personal purposes, you generally must divide your total expenses between the rental use and the personal use based on the number of days used for each purpose. You will not be able to deduct your rental expense in excess of the gross rental income limitation (your gross rental income less the rental portion of mortgage interest, real estate taxes, and casualty losses, and rental expenses like realtors’ fees and advertising costs). However, you may be able to carry forward some of these rental expenses to the next year, subject to the gross rental income limitation for that year. If you itemize your deductions on Form 1040, Schedule A (PDF), Itemized Deductions, you may still be able to deduct your personal portion of mortgage interest, property taxes and casualty losses on that schedule.
There is a special rule if you use a dwelling unit as a personal residence and rent it for fewer than 15 days. In this case, do not report any of the rental income and do not deduct any expenses as rental expenses.
To make sure you do it right, Gibney recommends you create a spreadsheet to consider all the costs.
“Make sure to include additional expenses, such as additional insurance — you need to alert your insurance carrier that you are renting — cleaning services, advertising, commissions if you use a broker to rent, and more,” he said.
You’ll need to know all those costs for the long-term, too, in case you ever sell the home.
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