Bio: Jonathan Sanchez is a real estate investor and personal finance blogger for Parent Portfolio. He owns a small real estate business that operates a couple of investment properties in his local market. He aims to help others understand their money and generate passive income. He’s also been featured in Business Insider, USA Today, and FOX Business.
Passive income is the key to reaching financial freedom. I’m a firm believer in real estate investing and the wealth it can provide. In particular, vacation rental properties offer a different kind of value compared to long-term rental properties.
Whether you invest in real estate or the stock market, you always need to make sound decisions. This article will go over the different things to consider when investing in vacation rental properties.
Purchasing a Vacation Rental
The two common ways to acquire a vacation rental is through a second home mortgage and a 1031 exchange.
Second Home Mortgage
More than likely, you’ll finance the purchase of a vacation rental property. Leveraging bank financing is the most powerful thing in real estate.
With stocks, you can only buy $20,000 worth of stocks with $20,000. However, in real estate, you can buy a $200,000+ property with $20,000.
Investing in a vacation rental property is not necessarily the same as buying a primary residence. However, qualifying for a second home mortgage can provide more opportunities than a non-owner occupied rental property.
For example, a bank usually requires an investor to make a 20% to 25% down payment when financing an investment property. On the other hand, banks only require a 10% down payment for a second home mortgage. This low down payment allows you to gain more value with lower investment.
For a property to qualify for a second mortgage loan, an owner must meet the following requirements:
- Must be at least 50 miles away from the primary residence
- Must be occupied by the owner for a portion of the year
- Must be a one-unit dwelling (i.e., single-family homes, beach houses, condos, etc.)
- The borrower must have exclusive control over the property and not given entirely to a property management company
Contact your banker and share with them your interest in a second home mortgage. An experienced banker can help you reach your investment goals.
I recommend working with a local banker compared to a banker at a “big name” bank. The interest rate with a local bank may be a point higher. However, the relationship is invaluable!
One of the great benefits of real estate investing is the tax benefits; one, in particular, is the 1031 exchange rules. A 1031 exchange is a tax code that allows a real estate investor to defer paying capital gains tax after selling an investment property. The investor can use the saved money to purchase a replacement property of equal or more value.
For example, an investor purchased a single-family house for $100,000. After some time, the property increased in value, and the owner sells the property for $300,000.
Usually, the government will tax the investor for the $200,000 profit. However, with the 1031 tax code, the investor defers paying tax and uses it as a down payment for a 14-unit apartment complex!
An investor can use a similar strategy to acquire a vacation rental. However, there are additional requirements that an investor must follow to avail of the tax code:
- Must rent the property for at least 14 days
- Personal use of the property cannot exceed 14 days or 10 percent of the number of days a guest stays at the property within the year
For example, if guests occupy a vacation rental property for 250 days within a year, the owner can use it for personal use for no more than 25 days.
Select the Right Location
Selecting the right location for your vacation rental can pay dividends for your investment. You need to invest in an area that can justify charging a premium to guests. For example, a vacation rental within walking distance to the beach can demand a higher daily rate than a property that is miles away from the beach.
You also need to choose your vacation rental destinations strategically. Figure out who you are marketing to and see how you can use that to your advantage.
For instance, people living in the Midwest, such as Omaha, would prefer to spend their winter vacation in a warmer state, such as Florida. Orlando is a popular tourist destination mainly because of Disney World.
However, the drive from Omaha to Orlando takes 22 hours. On the other, the drive from Omaha to Panama City Beach takes about 18 hours. Parents traveling with rowdy kids will gladly choose a vacation spot they can reach four hours sooner!
Advertise Your Vacation Rental Property
The most popular way to advertise your vacation rental is by posting it on a vacation rental online marketplace, such as Airbnb, VRBO, and Flipkey. For a fee, these websites help guests easily find vacation rental properties and allow them to leave a review on their experience.
They also prefer to recommend properties with excellent reviews because it's a sure-fire way for them to make money. Therefore, your guests must have a great experience, which helps you successfully promote your business.
Furthermore, satisfied guests are more likely to re-book a stay at your property again. You can take advantage of this opportunity and have them make a reservation directly through your website, saving on fees from Airbnb and VRBO.
A vacation rental can generate a sizable income ranging from $10,000 to $50,000 in profit. However, you can’t just buy any property and expect to make a return on your investment.
There are numerous expenses to consider when purchasing a second home, such as an extra mortgage payment, property management, and hiring a cleaning company. Be sure to analyze the market you want to invest in because the fair market rental rate can vary throughout the year.
Lastly, another benefit of owning a second home is participating in a home exchange program. This kind of program allows owners to swap their vacation rental to stay in a different one for free!
Do you own long-term rental property? Are you still looking for your first property? Share your real estate investing strategy and tips below.
Josh's Note: Jonathan has more experience with real estate investing than I do although I do own one rental property. I think real estate investing is a great way to earn passive income. He has some good insights if you want to start investing in short-term rental properties instead of owning rental property.
Josh founded Money Buffalo in 2015 to help people get out of debt and make smart financial decisions. He is currently a full-time personal finance writer with work featured in Forbes Advisor, Fox Business, and Credible.