Twice as nice
The huge potential market of second homes.

See how to tap into the second-home zone.

by Tom Kelly   The fondest memories of my youth are of family vacations—simple times of digging our toes into the sand or paddling around on the water. I can still feel the tight-fitting orange life preserver pushing against my face as I sat studying my father while he rowed a red rowboat on a mile-high mountain lake.

Hoping to create similar memories for our kids, my wife and I bought a modest cabin on a remote mountain lake more than 20 years ago. And, if you ask our children about the special times of their youth, the carefree days around that cabin would lead all of their responses.

A second home is worth so much more than the appreciation, and possible rental income, that come with most single-family homes in this country. Real estate agents often underestimate the emotional tug attached to a second-home purchase.

When I look at the numbers provided by the National Association of REALTORS® of the potential second-home market, I not only know most of those places will be valuable investments down the road but also invaluable investments in the family experiences that will take place there. Stock certificates are pretty, with great colors, cool writing, and embossed letters. Unfortunately, owners can’t sleep in them or stand on them to watch the sunset with a cold one. Stocks (hopefully) make money. A second home provides many different kinds of satisfaction that money can’t buy. However, if sold, it typically will provide money, too. It may also supply your customers with other financial benefits along the way. Let’s consider some of those monetary benefits as possible selling points for existing clients and new prospects.

Versatile, affordable financial instrument
A second home can serve three purposes over time—investment, vacation, and retirement. A second home also can be a long-term tax shelter for future retirement. For example, if your clients are a married couple in their mid-thirties who plan to slow down at 50, they can buy a rental home disguised as vacation home, furnish it, enjoy some personal-use time, and have renters pay for it. When they have whittled every shred of tax advantage out of it, they can move in and convert it to a full-time private residence while still renting it out a couple of weeks a year. And because most mortgages “front-load” interest, they will have used up most of the tax deductions from the mortgage in the 15 years they were working and renting out the home.

In the later years of the mortgage, when interest deductions are relatively low, they probably will be less concerned, because their income will have fallen off (having promised to slow down at age 50). They can sell their primary residence, pocket the gain, and retire in their second home.

In addition to appreciation, another underestimated aspect of second homes is the way to afford them. Buyers can own a second home with an equity investment of no more than 20%, perhaps coming via a home-equity loan on their primary residence or by tapping into other assets. In fact, there are programs with even less than a 20% downpayment. Most people can’t do this with stock. Buyers need to pay the entire price of the stock. So, when the price of a stock rises 5%, they make 5% on their money. If their second home rises by 5% in value, the return is upwards of 25%.

And speaking of stocks, the skittish conventional financial markets have consumers looking to real estate sooner—and second homes in particular­—as a larger piece of the family portfolio. That’s a good thing. Stocks can move a great deal in both directions. This can make stock ownership very risky, with profit largely dependent on timing. If share owners cashed out in December 1999, returns were huge; if they waited a year, they probably lost a great deal of money and sleep. (Have you ever tried to put a monetary value on sleep?) House prices fluctuate, but typically within a lesser range. Though real estate prices may not shoot up the way stock prices do in a bull market, property markets don’t typically crash the way stocks do when the bull runs out of steam. There’s a reason real estate makes up a large portion of the wealth of most American households, and there’s no reason not to add to it.

Jumping right in or using a stepping-stone process
The second-home process can be a one-time purchase or a couple of stepping-stone moves designed to get your customers where they want to spend most of their battery-recharging time. The best way to get in the door of a second home is not necessarily during a busy summer weekend when all the emotions of the entire family drive them to craft a hurried purchase-and-sale agreement. The best way might be to take a preliminary investment step, perhaps purchasing a fixer-upper in the neighborhood near their primary residence, rent it out for a year or two, then “trade” it via a 1031 Tax Deferred Exchange for that perfect place on a lake or golf-course property. They rent out the lake place during the next two years while using it themselves for two weeks of vacation, then shift the status of the property to a second home.

That way, they defer the gain on the fixer-upper that they traded for their eventual second home. Later on, when the kids leave home, they can sell their primary residence, pocket up to $500,000 tax free, and retire to their lake home. You have helped them to see how one property can serve three purposes over time (investment, recreation, retirement) while avoiding any capital-gains tax liability.

By buying one property—or series of properties—and having renters pay for it, then selling the property via the 1031 exchange and buying one that’s more to their liking, your customers can defer the gain on the rental property. Don’t like their new neighborhood? Sell the home while it’s still a rental property and find another via another 1031 exchange.

How is that possible? Not only is it possible, but it also is OK with the Internal Revenue Service. The intention at the time of the exchange is the only relevant fact. Taxpayers can thereafter change their mind and convert the usage of the property. However, since Uncle Sam cannot look inside their brain to see what their intention was, the IRS will examine the “objective manifestations of intent” and attempt to determine what the intention truly was. (There are other rules regarding 1031 exchanges, and tax implications vary depending on specific circumstances, so your clients would be wise to seek the appropriate professional help.)

For example, let’s say your client, Electric Eddie, a longtime electrician known for his speedy house calls, owned one rental property—a cute duplex in Houston you helped him buy for $50,000 that is now worth $250,000. You know that Eddie is an avid golfer, and you also know of another person who would love to sell her home near a golf course in Galveston. So, you encourage Eddie to sell his $250,000 duplex and buy the $350,000 Galveston home via a 1031 exchange. You point out to Eddie that the Galveston house would bring premium rental income from vacationers seeking a relaxing retreat. That rental income would more than cover the $100,000 mortgage payment, taxes, and insurance of the home.

After renting the Galveston home for two years and using it for two weeks each year for his own vacation, Eddie decides he really loves Galveston. He stops renting the place and uses it himself most every weekend. Three years later, Eddie lists his primary residence in Houston with you and he pockets a tidy, tax-free profit and moves into the Galveston home. He keeps busy by playing golf and solving small electrical problems for his golfing buddies. You have received the commission on the duplex, a referral and commission on the Galveston house, and eventually a commission on Eddie’s primary residence. More importantly, you have shown Eddie the way to a lucrative investment, recreation, and retirement home.

NAR survey shows enormous potential market
The second-home survey—the largest ever undertaken by NAR—revealed the market was far greater than any analyst believed possible. There were 415,000 new and existing single-family second-homes sold in 2000, up 40% since 1995. More importantly, as larger numbers of Americans reach their forties and fifties, the vacation-home market is expected to increase by 100,000 to 150,000 new sales each year during the next decade.

The typical second-home buyer earns about $69,800 a year. That means the typical vacation home is not a million-dollar house. They are recreational properties that tend to be smaller and less costly than primary residences. Cottages, cabins, and condos are much more common than expansive estates. They are found in every environment (river, lake, mountain, gulf), as many buyers prefer locations close to home rather than a big-name destination resort. That means there’s probably a second-home destination not far from you.

Most REALTORS® fit the profile of second-home buyers. And, you’ll be surprised how many of your existing customers and new referrals fit it as well.

While your customers will be surprised by the number of days they can rent out their second home to people they know and, through a management company, to those they don’t, they may choose not to. I’m in no hurry to turn our lake place into a rental property for most of the year. The extra cash would be nice, but I’d like to keep the place available now so that our family can pack up and go there at a moment’s notice.

And that’s probably because of the memories my dad provided for me, and my wanting to extend the same times to our kids. This is the sixth summer my dad’s been gone. And I wish, on every summer day in the sun, for another moment in that rowboat with him.

Tom Kelly, former real estate editor for The Seattle Times, is a syndicated columnist and talk show host. His new book, How a Second Home Can Be Your Best Investment (McGraw-Hill), was co-written with John Tuccillo, former chief economist for the National Association of REALTORS®, and is available in local bookstores. He can be reached at news@tomkelly.com.

Photos © Corbis & Brand X Pictures.

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