Summer always brings lots of questions about the wisdom of owning a vacation property in a resort location. Whether you are thinking of warming up at the beach or cooling off in the mountains, here are a few frequently asked questions that will point you in the right direction:

Q: Can a vacation home be a good investment?

A: I guess that depends on your definition of a good investment.

If you are looking for a second home that allows you unlimited personal use and costs you little or nothing up-front or monthly, your search may be a long one.

But if you are willing to settle for limited personal use and you are able to make a substantial cash investment, it is certainly possible to expect a continuing stream of rental income that can help pay for the property over time.

In addition, I believe that vacation real estate will likely go up in value in the years ahead.         

Q: What are the exact differences?

A: In the first scenario, you would be purchasing a secondary residence for your exclusive use. That precludes some major tax benefits. In addition, you made little or no down payment on your purchase, which likely caused you to accept a piggy-back loan or a loan with higher than market interest rates. That fact will hit your wallet month after month, perhaps for thirty years.

In the second scenario, you made a business decision to purchase an investment property, which just happens to be located in a resort location.

Because this is an investment property, your primary concern is to hold down costs and maximize income throughout the year. This increases your chances of offsetting monthly expenses. It also opens up access to a series of substantial tax benefits.

Q: What kind of tax benefits are we talking about?

For a second residence, the only tax benefit you can take is a deduction for the interest you pay on the acquisition mortgage and the property taxes. Everything else related to your vacation home is considered a personal expense.

In dramatic contrast, once you decide to make a business investment in a resort location, the deductions begin even before your make your purchase.

For example, if you decided to explore the possibility of owning a rental condo on Tybee Island, you would certainly want to acquaint yourself with the marketplace before you make your purchase. So I would recommend a trip there, perhaps multiple times, while you met with real estate professionals and explored the opportunities. Of course, all your travel costs, including gas, motel, food, and reasonable entertainment expenses would all be tax deductible.

Then it gets better.

Once you make your purchase, all reasonable and prudent expenditures related to the property become deductible except principal payments toward the purchase of the property.

So, everything you buy to finish the property is tax deductible. It means your entire monthly payment, with the exception of principal, is tax deductible. It means your utilities, your yard service (or condo fee), your decorating costs, your management costs, all become tax deductible to you.

And it gets better than that.

It means that you get to take a tax deduction every year for depreciation of the property. So for each hundred thousand dollars of rental property you
own, you get to take an additional deduction of about $3,000 against any other income you may have. This is called a tax shelter, and there are some limitations on its use, but it generally is available to most taxpayers.

Q: But what about when I get ready to sell years from now?

A: Again, your tax treatment when you sell depends on how you have handled the property during your years of ownership.

If you treated the rental as a second residence, you get no break when you sell. Instead, any profits are treated as long-term capital gains and are taxed at 15% federal and 6% for the state of Georgia.

Remember that the $250,000 "exclusion of gain" rule does not apply here because this was never your principal residence.

On the other hand, if you treated this rental all along as an investment, you would be eligible to employ section 1031 of the IRS code, and take advantage of a "tax-deferred" exchange. Under this scenario, you could sell your beach house, find other investments that you happen to like better for various reasons, then purchase them using the proceeds of your rental house sale. No tax would be due whatsoever if the transaction is structured properly.

Q: But how can I use the property myself if I have it rented out all the time?

A: The IRS restricts personal use of an investment property to the greater of two weeks per year or ten percent of the annual days rented. So you are guaranteed at least two weeks at the beach every summer.

As always, it's a good idea to talk to your tax professional regarding your personal situation, but in general, having an investment house beats having a second residence every time.