Vacation Rental — Structure Your Real Estate Investment for Passive Income as Well as Personal Pleasure

A vacation rental investment is considered by the investor for a variety of reasons. Typically the investor is looking to offset the costs of overhead for the vacation rental property with the income generated from short term rentals. Appreciation in the value of the property is where the investor is looking for the greater return on investment. The aspect of the intangible value of personal use however, should be a large consideration in the overall investment calculation.

Vacation Rental Income

Rental income generated by the vacation rental property is credited directly to the owner of the property. Although the IRA is supporting the purchase of the vacation rental, rental income is not funneled back into the IRA but is available to the investor to use as he wishes. Taxes, maintenance fees or structural expenses incurred by the vacation rental property may be paid for by non IRA monies. The investor is not limited to using IRA monies exclusively for property expenses as is required with a self directed IRA real estate program.

SAFE HARBOR® directed IRA

This type of IRA investment is SAFE HARBOR® directed. What this means is that while the IRA is supporting the purchase of the vacation rental the IRA itself is placed in an interest earning account where preservation of capital to insure long term support of the real estate purchase is the primary function. So, with the OUTSIDE® structure the investor owns two assets concurrently – the vacation rental and the IRA. It is the projected earnings of the IRA combined with the anticipated capital appreciation of the vacation rental along with the rental income and tax advantages for the property that must collectively be considered to arrive at benefit to be gained from a vacation rental investment configured within the OUTSIDE® structure. Furthermore, the diversification of the concurrent investments offers the investor a greater potential return while at the same time providing broader investment protection.

Vacation Rental — Return on Investment

Let’s first examine the potential capital appreciation of the vacation rental investment. Because the OUTSIDE® structure requires the investor to use leverage, the actual cash investment in the vacation rental is a mere fraction of the total value of the vacation rental investment. Therefore the returns are measured based on what is termed the “cash–on cash” return on invested capital or investment. This method of investing leverages up the percentage of your return. For example, using gross figures for simplicity: A $100,000 property is purchased with $20,000 down, the balanced is financed by a traditional mortgage. The property is then sold for a $15,000 gain. A return of $15,000 on a $20,000 investment results in a 75% return on investment, (ROI). (This simplistic example does not take into consideration time held in the investment.) Market conditions can vary widely in different geographic regions and historically housing has experienced periods of escalated appreciation, flat conditions and some periods of value adjustment. Over the long term however, statistics show a nationwide average of an annual 5% appreciation for residential real estate. Secondly, since one of the reasons for purchasing a vacation rental is the income that investment will produce – that income should be considered when making the investment decision.

Now let’s look at the IRA side of the vacation rental investment. To comply with the OUTSIDE® structure the IRA must be SAFE HARBOR® directed. The SAFE HARBOR® account offers several different earnings opportunities, all with the necessary requirement of protection from loss of capital. Fixed indexed account opportunities provide unlimited upside earnings potential, however, for the purpose of comparison in arriving at a vacation rental investment decision a conservative 5% annual return should be used.

Taxes are an element to be considered in every investment decision. Those investors familiar with Self Directed or Trustee Directed IRA real estate termed by Uranga & Associates, the INSIDE method, understand the approach of a tax deferred investment. All expenses related to the investment must be paid for from IRA monies and all income related to the investment must return to the IRA. Income tax at the highest rate within the investor’s income tax bracket is paid when the IRA is eventually distributed. For many investors, in today’s tax environment, approximately 40% of the value of their IRA will eventually go to the IRS. Where a vacation rental investment is structured by the OUTSIDE® method in a SAFE HARBOR® directed plan, income tax liability on the IRA is satisfied at the time it is utilized for the vacation rental investment by applying tax offsets applicable to the investment real estate. This significant difference between the two methods is where the OUTSIDE® method can offer the investor additional savings which will equate to a higher return on investment.