In August 2023, real estate analytics firm Redfin published a commentary on a data set collected by Optimal Blue, a respected capital markets platform, from the American vacation property segment. The comments by Redfin analysts underscored the cyclical nature of the market for vacation homes, which experienced a sharp decline after many quarters of high activity during the COVID-19 pandemic.
We will reference the report a few times in this article because it calls attention to an important aspect of vacation property ownership, which is that it should always be approached and understood as a business investment.
There’s an adage in the American real estate industry about every homeowner being a property investor. The rationale of this adage asserts that homes should be categorized as market assets. Before the Great Depression, homes were mostly managed as personal residences with intrinsic values; after World War II, they became commodities to a certain extent.
Commodities are subject to market forces like supply and demand, and they are also at the mercy of multiple factors that result in cycles. This is important for prospective vacation home investors to understand before they enter a market segment that is more dynamic than residential and commercial real estate.
With the above in mind, the good news for potential vacation property buyers is that the market is widely expected to gradually improve from now until the summer of 2026. We’ll explain later why the market skyrocketed during the pandemic, and why most projections are positive for a gradual return to value appreciation and market activity.
For now, let’s review the basics of vacation homes, their characteristics as investment assets, and legal details about ownership.
Second Homes, Vacation Homes, or Investment Properties?
The practical and legal definitions of vacation homes have changed significantly since they were first sold to Americans in the late 19th century when real estate agents turned a book titled “Adventures in the Wilderness” into a marketing plan. One section in the book recommended the acquisition of properties in the Adirondack Mountains region of upstate New York, which was a major tourism hub during a period of substantial wealth creation.
By the mid-20th century, increased affluence and improved transportation motivated developers to get into the game with the construction of resorts and vacation communities. Then, real estate agents took advantage of the trend by showcasing the vacation home potential of more destinations.
In the mid-1960s, resort developers created the timeshares business model to finance large-scale projects, often in beachfront destinations. By selling fractional ownership of individual units, developers could spread the cost of construction and maintenance over multiple buyers.
The emergence of this business model prompted the Internal Revenue Service (IRS) to pay closer attention to this real estate segment, which was growing rapidly in terms of revenue potential and market sophistication.
IRS Rules for Vacation Homes
The Tax Reform Act of 1986 began a new era for vacation property ownership. In the practical sense, owning a vacation home implies that it is located in a travel and leisure destination; plus, it is not your primary residence because you live elsewhere for most of the year.
When the IRS rules changed through reform, vacation properties were placed into the broader category of second homes for taxation purposes. Second homes can be vacation homes, investment properties, and even timeshares under the IRS rules for calculating and collecting capital gains tax; however, there is some interchangeability to consider.
Within the second homes category provisioned by the IRS, properties not rented out for more than 14 days per year, or 10% of the total rental days, are typically personal residences. Let’s say you own two homes, one in the North Shore of Long Island and the other in Key Largo.
Practically speaking, both could be vacation homes because of their locations; however, the Keys are far more attractive during the winter, so that’s where you stay from early December to late March. Since you are staying in Long Island longer than in Florida, the former is your primary residence while the property in the sunny Keys is a second home.
Staying with our North Shore and Key Largo example, let’s say the latter property is mostly empty while you live and work in Long Island. Under IRS rules, you can hire an Airbnb agent to list and rent the house in the Keys to guests with deeper pockets, but doing so for more than 14 days in a year would reclassify your vacation home as an investment property, thus making it ineligible for the capital gains tax exclusion.
This means that any profits you realize from selling your Key Largo vacation home could be taxed at a 20% rate if your annual taxable income was more than $499,750.
Mortgage Lending for Vacation Homes
Beyond the IRS designation of a vacation home as an investment property, there are other financial distinctions to consider. The Federal Housing Finance Agency (FHFA) sets conforming loan limits for Fannie Mae and Freddie Mac certificates.
For second homes designated by the IRS, the conforming limits are higher for vacation and investment properties. Along with debt-to-income down and interest rates, down payments are also higher. All in all, mortgages on vacation homes are more expensive regardless of whether they qualify for the capital gains tax exclusion or not.
The documentation requirements, income verification, and credit scoring rules for mortgage applicants to finance vacation homes are more stringent than for primary residences. If you don’t qualify for a Fannie Mae or Freddie Mac conforming loan, you can find private lenders offering alternative funding that will be more expensive, riskier, and with lower protection against foreclosure.
The Financial Realities of the Vacation Homes Market
In the Redfin report we mentioned in the beginning, the boom of the vacation property market during the COVID-19 pandemic was explained as follows: A prolonged period of low mortgage interest rates and work-from-home (WFH) mandates combined to cause high demand for vacation properties, particularly located far from metropolitan areas with high rates of coronavirus infections.
What started as a market opportunity with WFH strategies for affluent property buyers evolved into a boom cycle. The initial wisdom was: “If you have to WFH, might as well do it from a resort town.” As demand grew, other investors rushed into the market as they anticipated the easing of travel restrictions and millions of Americans browsing Airbnb listings.
All boom cycles must come to an end; such is the unwritten law of all financial markets, and for vacation homes, the end began to unravel in late 2021. As the economy began to recover and inflation started to rise, the Federal Reserve began to increase interest rates. By 2022, the FHFA had increased fees on conforming loans for all second homes, and dozens of local governments began cracking down on short-term rental agreements such as the ones involving Airbnb guests.
The positive forecasts from many real estate analysts for the vacation property market are based on the inevitable lowering of interest rates by the Federal Reserve. Developers are waiting on a more favorable lending climate to increase construction in resort towns.
Municipal rules on Airbnb stays will need a few months to stabilize. Finally, vacation property owners who bought at the height of the boom cycle are coming to terms and lowering their sales prices.
Insurance and Liability
When you purchase a vacation property with the intent to use it as a short-term rental, there are insurance and liability issues you need to consider to protect yourself financially. If you are using a rental service such as Airbnb or VRBO, your rental agreements will include a one-million-dollar liability coverage provided by the company.
As the owner, you will be subject to the premise liability laws in the state the property is located. You will need to acquire additional insurance to provide coverage in case a guest or user is injured on your property.
House hunters interested in vacation homes for enjoyment or to generate revenue from rental payments should evaluate market conditions before making a purchase decision. The profit potential of this market has not diminished at all; vacation homes are very popular, and post-pandemic tourism is breaking activity levels, but we are still going through a period of adjustment.
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