Want to Invest in Short-Term Rentals? Do Your Homework First

Short-term rentals are an attractive investment opportunity. With the low-risk profile of residential real estate and higher profit potential than long-term rentals, vacation rentals are attracting everyone from experienced real estate investors to first-timers looking to break into the industry. However, owning a vacation rental isn’t as straightforward as it seems. Here’s what you need to consider before purchasing an investment property.

Home Prices and Rental Profits: Where’s the Sweet Spot?

Home prices are the single greatest factor affecting short-term rental’s profits. Outside of luxury properties, most short-term rental rates fall in line with hotel prices. Home prices, on the other hand, vary widely. While cities like New York and San Francisco are popular travel destinations, they’re not the best place to buy an investment property. Short-term rental rates won’t put a dent in mortgage payments in these high-priced cities. However, there are many popular cities that are much cheaper to buy into, leading to higher income potential from your investment.

Even in an affordable market, investors should understand the value of the home they’re buying. The popularity of short-term rentals can drive up home prices, and first-time investors are susceptible to getting swept up in the excitement and overpaying. Using an online home worth tool is a good place to start in determining the actual value of a property (Phoenix homes average $285,000). However, investors also need to factor in the cost of improvements. Compare the purchase price plus remodeling costs to the price of turnkey homes in the area to determine if the property is a wise investment. And always work with experienced realtors who know the neighborhoods and market conditions in your target market.

Investment Property Financing Challenges

You’ll appreciate that affordable market when shopping for a second home mortgage. Lenders have more stringent requirements for second home mortgages, especially when it comes to rental properties. Real estate investors need a minimum of 20 percent down because private mortgage insurance won’t cover rental properties. Interest rates average 0.25 to 1 percent higher on investment property mortgages, so some investors opt for an even bigger down payment to secure a lower interest rate. If you have considerable equity in your primary residence, you may be able to tap it for a large down payment.

There’s a creative solution for investors who can’t qualify for a second home mortgage: Buying a multi-unit property and living in one unit while using the other as a short-term rental. As long as the property is owner-occupied, buyers can use an FHA loan to buy with as little as 3.5 percent down and rent out the extra unit.

Short-Term Rentals and the Long Arm of the Law

If you want to buy in a city where short-term rentals are in high demand, expect some rules to stand in your way. Concerned over a tight housing market, cities are increasingly regulating short-term rentals. While it’s easy enough to comply with existing regulations, short-term rental laws are subject to change. Consider purchasing a property that could convert to a long-term rental to mitigate risk.

Vacation Rental Taxes and Deductions

Short-term rental owners must pay taxes on business income to the IRS as well as hotel, lodging, excise, and other taxes to state and local tax authorities. Some rental platforms may collect taxes on hosts’ behalf. However, property owners are responsible for filing their own tax returns. The upside of paying business taxes is deducting business expenses, and for vacation home investors, there’s a lot to deduct. These are the expenses you can deduct when filing rental income taxes:

●       Mortgage interest

●       Property tax

●       Depreciation

●       Insurance premiums

●       Maintenance and repairs

●       Utilities

●       Permits and licensing

●       Legal and professional fees

●       Travel and transportation

●       Property management fees

●       Marketing expenses

●       Cleaning services