Financing a vacation rental

7 Replies

Hello,

My wife and I are looking at doing a 1031 exchange and purchase a property on the Oregon Coast. We understand that it's not very realistic to expect that a vacation rental will be the greatest investment but this is a hybrid endeavor. Her part of the 'vacation', mine is the investment portion of it. 

We are only just starting our search and have gotten in touch with a local realtor (who happens to be registered on BP) so we can focus our search rather than be all over the place. 

I was wondering if anyone has experience with this vacation rental scenario. Will a financial institution ever take into consideration past vacation rental performance as part of the picture for financing. We could get a decent amount of financing as is, but an additional 50-100k would really open up the possibilities. We would certainly make sure that we could afford the 2nd home with no rental income whatsoever but that's not a scenario we are assuming to be the norm either. 

If banks do look at past rental history then looking at established rental properties may be our best bet. Any ideas?

The important thing that you must keep in mind is that in order to qualify for 1031 Exchange treatment you must have the intent to hold for rental, investment or business use.  The more that you use the property for your personal vacation the more risk you will have that the 1031 Exchange could be disqualified because it was not held for rental, investment or business use.  It all boils down to your intent. 

Revenue Procedure 2005-18 was issued by the IRS that specifically addresses 1031 Exchange into or out of second homes and/or vacation properties.  Generally, if you rent the property for at least 14 days per year and limit your personal use of the property to not more than 14 days (or 10% of the number of days that you actually rent the property out), you will qualify for 1031 Exchange treatment.  This is a safe harbor, which if followed means the IRS will not challenge your 1031 Exchange.  There are other strategies and usage scenarios that could qualify, so remember that it all boils down to your intent and whether you can prove your intent to hold for rental or investment purposes if you get audited.

Along those same lines, @Bill Exeter  , let's say that @Stijn T.  acquires the property and rents it out by the night for 200 nights per year and keeps his personal usage to 20 days or less.  That keeps him within the safe harbor as you mentioned. How long does he have to keep this up?  Forever?  Or, could he do that for some period of time, say one or two years, and then increase his usage outside of the safe harbor?  

Then what happens if five years down the road he moves in and makes it his primary residence?  Can he then sell it two years later and use the primary residence exclusion?  Or would the original acquisition under IRC1031 preclude him from using the primary residence exclusion forever as it relates to this property?

hi @Stijn T.  

I've too thought about this and looked into this.  Here are some things that I found out too that might help you with the decision:

- unless self-managed, management companies aren't cheap

- not sure about oregon, but some vacation rentals need to pay transient occupancy tax (there is probably a certain threshold of days rented)

That being said, I have also spoken to other investors who are quite bullish on the economics of vacation rentals.  Some friends and myself have also had very nice success doing short-term rentals and furnished rentals on vrbo.com and airbnb

best of luck with your endeavors!

Originally posted by @Brian Burke :

Along those same lines, @Bill Exeter , let's say that @Stijn T.  acquires the property and rents it out by the night for 200 nights per year and keeps his personal usage to 20 days or less.  That keeps him within the safe harbor as you mentioned. How long does he have to keep this up?  Forever?  Or, could he do that for some period of time, say one or two years, and then increase his usage outside of the safe harbor?  

Then what happens if five years down the road he moves in and makes it his primary residence?  Can he then sell it two years later and use the primary residence exclusion?  Or would the original acquisition under IRC1031 preclude him from using the primary residence exclusion forever as it relates to this property?

Excellent question!  He certainly has some flexibility here, but he should give some serious thought to his ultimate exit strategy so that any changes he makes does not cause problems with his exit strategy. 

The safe harbor that I referred to only requires a two year period, so after the two year period he could certainly increase his personal use and/or decide to move into the property as his primary residence. 

Increasing his personal use will add risk if he wishes to 1031 Exchange back out later. 

Moving into and converting the property to his primary residence will change the use of the property completely and he would then fall under Section 121 of the  Tax Code.  His gain would be allocated between the number of years held as investment property vs. the number of years held/used as his primary residence.  If he rented it for two years and then lived in it for two years 50% of his gain would qualify for the tax-free exclusion as his primary residence up to the $250,000/$500,000 limit.

I don't have time to write an elaborate response right now, but thanks for the solid feedback everyone.

Originally posted by @Stijn T. :

I was wondering if anyone has experience with this vacation rental scenario. Will a financial institution ever take into consideration past vacation rental performance as part of the picture for financing. We could get a decent amount of financing as is, but an additional 50-100k would really open up the possibilities. We would certainly make sure that we could afford the 2nd home with no rental income whatsoever but that's not a scenario we are assuming to be the norm either. 

If banks do look at past rental history then looking at established rental properties may be our best bet. Any ideas?

We received an investment loan (from TD Bank, same low interest rate as on a conventional loan!) on our 3rd vacation rental property based on the income reported from the first two, as this new one had never been a rental. In researching loans we found all banks have different criteria. We will go back to TD, however, will never do an online loan again - will walk in and request face to face time, the online took forever. 

Be sure to get insurance that is specific to VR - they can be very expensive - we insure all ours with CBIZ which was significantly lower than all other quotes.  

Not related to the original question but do be aware that there will likely be increased upkeep on an Oregon coastal property.  I spent the first half of this year working in Astoria, OR (and I want property there, badly!) and have a house on the Puget Sound in Washington.  Winters are BRUTAL on the houses on the Oregon coast.  The Sound at least has islands to buffer some of it, but while I was in Astoria, I was truly surprised many of the houses were still standing.  The storms / rain / ice is no joke out there....

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