Vacation Property Loans? What’s the Scoop?

Some people buy homes, and run vacation rental businesses through them. They might even run their businesses from afar, through apps. And they do it without having to qualify for a loan based on their incomes.

These borrowers seek out an unconventional — yet popular — form of mortgage. Lenders approve these loans based on expected future income from particular investment properties.

Let’s take a look at these loans.

Debt Service Coverage Ratio Loans: When Lenders Expect Rental Income to Cover the Mortgage

In a time of Airbnb and Vrbo, a home in a popular holiday spot can generate income to pay off its loan.

Mortgage specialists call it the debt service coverage ratio (DSCR) loan. This type of mortgage appeals to entrepreneurs who plan to buy homes, rent them to tourists, and thereby cover the monthly payments.

How is the ability to pay calculated? Many of the lending companies look at the borrower’s assets, credit profile, and the expected monthly income. Some lenders subtract out the projected operating expenses. They order appraisals. Mortgage consultants take into account the typical rental income in the area for a comparable home — or leases already in existence at the home — to determine likely income. Because they are handled as business loans, these products can be faster and simpler to obtain than regular mortgages.

At Deeds.com, we have more thoughts on selling or buying a renter-occupied home.

There are a few drawbacks. For instance, borrowers can be subject to penalties if they want to pay off DSCR loans too early. They might have to wait three years or more to make the final payoff. But ultimately these terms depend on an agreement with the lender, and any applicable laws and rules.

To learn the particulars, a hopeful borrower would search for online DSCR lender, DSCR financing, or rental-based mortgage loans. Small lending businesses are cropping up in home-sharing hot spots to serve entrepreneurs.

How Risky Is This Practice?

Business loans always pose certain risks. There will always be a number of investor-borrowers unable to gain traction in their markets. And there will always be changes in the economy.

What if we get a recession, and businesses struggle? What if remote real estate owners run into unforeseen emergencies that they can’t handle from an app?

The plot thickens because DSCR loans themselves get pooled as investment products. So there are multiple layers of commitments tied into them.

At the end of the day, do mortgages based on short-term and per-night income create too much risk?

It’s All Good, the Lenders Say

Companies that issue these loans are confident. They think rentals are bound to be a good investment for a long time, given the shortage of homes available to buy.

The companies work to ensure the stability and safety of this segment of home financing in the following ways:

They handle vacation property loans as business loans. Investor-buyers of vacation properties pay higher interest rates than the prevailing rates for financing ordinary residences. A borrower’s larger payment, then, offsets risk.

Lenders examine the surrounding markets before they approve these mortgages. They focus on applicants who are already experienced with rental properties.

The investor-buyers need to show strong credit profiles, and their down payments can be nearly a third of their property prices. (But not always. Some of these loans require just 20% or 25% down. Terms can vary widely from lender to lender.)

Lenders have additional ways to protect their collateral. They might require, for example, three months of cash reserves in escrow — just in case renters fall behind.

In worst cases, where rental businesses flop, it’s easier to foreclose on these small businesses than on regular borrowers.

Can’t Homeowners Rent Out Their Personal Residences?

Buying a second home that you’ll occasionally rent out? That’s a “mixed use” property. The Internal Revenue Service will treat it as a personal home if you rent it out now and again, earning just a few days’ worth of income.

What’s just a few days? If you rented out the home 0-14 days during a year, proceeds are not treated as business income — as long as the home has been owner-occupied for more than 14 days. If your second home is a personal residence, there is no need to declare rental income on your federal return.

Frequently asked question of the day: Is setting up an LLC for your vacation rental business worth it?

In short, these properties are treated the same as the owner’s first home for mortgage interest deductions and property tax purposes. This is on account of the Minimal Rental Use rule, a special rule in the tax code for homes rented out fewer than 15 days in the tax year. The rule asks: Does your own use and enjoyment of your vacation home add up to the greater of either 14 days, or ten percent of the number of days you rented it out? If the answer is yes, then it’s taxed as a personal residence.

Even homeowners who enjoy their vacation spots more than two weeks out of the year are allowed to deduct some rental-use expenses on Schedule E. They just have to be pro-rated to reflect the ratio of rental days per all of the days the home was used.

Need the official breakdown? See how the IRS lays out taxes for renting residential and vacation property on the IRS website itself.

A Vacation Home, Rented 14+ Days, Is a Rental Property

The IRS treats a second home as a rental property if:

Renters are paying market rate to stay there for a total of 14+ days during the tax year.

The owner and friends occupy the home for (a) 14 days or fewer; or (b) 10% or less of the time the home is rented out at market value — whichever is higher. Time spent at the home to do upkeep and repairs doesn’t count toward these limits.

Owners who rent out to tourists will:

State the amount of rental income on Schedule E of the federal tax return.

Claim deductions including (but not limited to) their rental property expenses.

What are rental property expenses? Any relevant expenses. These could be the mortgage interest, property taxes, repairs and upkeep costs, regular bills, homeowner association fees if any, and so forth. Depreciation also shaves off some of the tax.

One more thing, though it won’t apply to everyone. Owners who rent out their homes for significant cash flows could be subject to Net Investment Income Tax. Read more about NIIT and its current income ceilings.

Please note: This article is offered as general information, and as a starting point for the reader’s own due diligence. Accountants and tax services can provide guidance specific to each home buyer’s situation and goals.

Supporting References

U.S. Internal Revenue Service (IRS): Publication 527, Residential Rental Property (Including Rental of Vacation Homes).

Deeds.com: I Rented Out My Vacation Home for a Week. Must I Report It? (Sep. 21, 2022).

Prashant Gopal for Bloomberg LP: Americans Are Building Vacation-Home Empires With Easy-Money Loans (Jun. 14, 2022).

And as linked.