Financing a vacation rental

[Stijn T.]

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?

[Bill Exeter]

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.