The 4 financial benefits of vacation homes

White piggy bank on beach

A vacation home can boost more than your spirits.

It can add to your wealth, as well.

Whether you're considering a glitzy condo on the beach, a cozy chalet on the slopes or a rustic cabin in the woods, there are four ways you can benefit financially.

Benefit 1. New tax deductions.

For most of us, our home is our biggest tax break. And a second home qualifies for many, if not all, of the same deductions.

If you spend at least 14 days a year in your vacation home, you get to deduct the mortgage interest on two separate homes for up to combined total of $1 million in mortgage debt. So, if you owe $500,000 on one and $500,000 on the other, you can write off all of the interest payments.

If you owe $600,000 on both, you can still write off the interest on the first $1 million, but not on the remaining $200,000. If you happen to own three homes you can write off the interest debt on only two of them -- but you get to choose which two.

That tax deduction applies even if the home is outside the country -- Canada, Mexico or anywhere else. There's a bit more paperwork involved, but you still get to write off the interest.

You also get to write off your property taxes in the same way that you do for your primary residence. In terms of an out-of-country home, the IRS may allow you to deduct your foreign taxes, but that's a job for your tax preparer to deal with.

Benefit 2. New source of income.

Since it's a vacation home, you can rent it when you're not there. The right property in the right location can even make enough money to pay for itself.

Doing that doesn't mean you have to forfeit all of the tax breaks, either. The IRS has many, specific rules about that, but here are the main points:

One cautionary note: Being a landlord is more complicated than you might think. You'll almost certainly need an accountant or tax adviser, for example, just to help you cope with all the financial issues.

Benefit 3. A second property for building equity.

Since most second homes are located where you want to live instead of where you have to live because of work, family or other commitments, many people keep their vacation homes longer than they do their primary residences. That gives you more time to pay down the loan and watch your vacation home appreciate.

Even though property values can and do fluctuate in some markets, the price of almost any home or property is likely to climb over time. That makes your vacation home a solid investment.

Benefit 4. Reduce your expenses in retirement.

Planning ahead and buying a vacation home that will become your primary residence when you retire can save a bundle.

By starting early, you're building equity and reducing your mortgage debt on your current and retirement residence. When you retire, the profit from your current home might even be enough to pay off the mortgages on both.

As an added bonus, unless you make more than a $250,000 profit on the sale of your home -- or $500,000 if you are married -- you don't have to worry about capital gains tax.
Since you'll have owned the vacation home for some time, you'll also know exactly what the upkeep, taxes and maintenance costs will be. There will be fewer surprises.

You should be aware, however, that a vacation home can be more difficult and a bit more expensive to buy.

A second home is a riskier investment for lenders because they know that when people get into financial trouble, they will do everything they can to protect their primary homes. If that means losing their vacation home, they'll let it go.

That's why, depending on your credit score and financial reserves, most lenders will require a down payment of 20% to 40% and charge from a quarter point to a full point more in interest.

If you do manage to get a vacation home loan with less than 20% down, you will also need private mortgage insurance, which is higher for a second home than it is for a first one.