Should You Buy a Vacation Home With a Mortgage or Cash?

If you're mulling over the purchase of a vacation home, congratulations.

But should you buy a second home for cash or a mortgage?

There are multiple considerations to weigh, primarily driven by the tax code.

Interest on your mortgage for a second home is as deductible as the mortgage interest on your first home.

You can write off 100 percent of the interest you pay up to $1.1 million of total debt secured by your first and second homes when that money was employed to acquire or improve your properties.

What constitutes a second home?

The breadth of what is considered a second home might surprise you.

According to the IRS,  "A home includes a house, condominium, cooperative, mobile home, house trailer, boat or similar property that has sleeping, cooking and toilet facilities."

Your second home can serve as a pied-à-terre in Greenwich Village—so that you don't have to drive to the suburbs after a grueling day on Wall Street—or be the cruising sailboat you use to escape from Hollywood to the Channel Islands.

Rental complication for a vacation home

If you have a second home that you do not rent out to anybody else during the year, it qualifies as a second home without your having to use it.

Let's say you've come to realize that it's silly that you barely use your slope side condominium in Vail, so you start renting your vacation home to other skiers.

But you must live in it yourself for it to still qualify as a second home.

You have to use it for more than 14 days or more than 10 percent of the number of days during the year that the home is rented at market rates, whichever is longer.

The home would still be considered a personal residence, so you deduct mortgage interest and property taxes just as you would for your principal home.

If you do not clear this usage threshold, the IRS considers your home to be rental property and not a second home.

That 14-day time frame is important in another way too.

If you rent the home for 14 days or less, you can pocket the money tax-free.

If you rent for more than 14 days, that's another way that your home gets considered rental property.

You must report all rental income offset by pro-rated rental expenses based on the percentage of the year the home is rented compared to the total number of days it is used by you.

Rentals complicate your chance of getting a mortgage.

Lenders contend that rental homes are riskier since renters are more likely to damage the property.

Many lenders now require an affidavit of occupancy where owners assert that the home will be owner-occupied.

If the lender finds that your home no longer qualifies, this affidavit could give them the right to demand immediate repayment or change the terms of your home loan.

As you can see, due to the tax deductions, getting a mortgage is still the better way to buy a second home.

But if you plan to rent it to tenants for more than 14 days annually while not using it yourself for at least 14 days annually, it could make better sense to pay cash.

Click here to find out the best second home refinancing rates.