6 steps to making a vacation home pay

Updated By Richard Barrington

Earning rental income from a vacation home while also getting use out of it yourself sounds like the best of both worlds. And, it can be, if you take the right steps.

But renting out your vacation home shouldn't be a casual decision. First of all, it means making a commitment to being both a homeowner and a landlord. That requires accepting limitations on your personal use of the property and being ready to respond to unexpected situations.

Also, making a vacation home pay means treating it as a business. That entails doing some planning and crunching the numbers. The following are six steps toward making a vacation home profitable:

1. Estimate rental income from vacation homes in the area

Check out listings for comparable local properties that are being offered as vacation rentals to see what they charge. Try to find as many examples as you can to get a representative sample of how much income vacation homes in the area generate. Search offerings on Airbnb and Vacation Rental by Owner (VRBO), but also check local Craig's List ads and newspaper listings.

You can use an average of these comparable rents as a starting point for a rental income projection on your property, but consider the low end of the range if you want a sense of what the worst-case scenario might be.

2. Determine your likely vacation rental occupancy rate.

In many cases, you can't expect to be earning rental income from your vacation home 100 percent of the time that you aren't using it. VBRO.com allows you to see how many comparable properties in the area are booked for upcoming months, and how many are still available. Those properties that are still available are your competition, and the more competition the tougher it can be to rent your property out.

The supply and demand for vacation homes in your area factors into how many days annually you might be able to book renters, and so does seasonality. Your property may be in a warm-weather area that is in high demand in the winter months, but less popular in the heat of summer. Festivals and/or sports seasons may drive demand for rentals in your area at some times of year but not at others.

Remember to account for the amount of personal use you want to get out of the vacation home. The time you spend in the home cuts into the days when it is available to earn income.

Once you account for demand, seasonality and personal use, you should be able to estimate how many days a year you can successfully rent out your vacation home. You can then apply this number to the rent you expect to charge to estimate the annual rental income from your vacation home.

Related: Learn how to buy a second home

3. Check mortgage details for vacation rental property

If there is a mortgage loan on your vacation home, check to see whether the mortgage lender requires special insurance provisions to cover having tenants in your home.

In particular, if the property changes from being designated as "residential" to "rental," make sure your insurance policies fully cover that. "You should probably notify your mortgage lender that a change in status has occurred," says Keith Gumbinger, HSH.com Vice President. "The new status may trigger a change in the terms of your mortgage contract, required insurance coverages and more."

Even if it's not required by your mortgage lender, for your own protection you might consider extra insurance against damage done by tenants and against liability for injuries to tenants.

4. Calculate all potential costs from renting out your vacation home

Additional insurance is just one of the added costs you may incur when you rent out your vacation home.

You are already paying for the big ticket items -- mortgage interest, property taxes, homeowner's insurance and possibly homeowner or condo association dues. On top of that, with the increased usage that comes when you rent out your vacation home some of the secondary bills may ratchet up such as gas, electric and water. Several additional out-of-pocket costs can crop up:

• You might sign up for WiFi and satellite TV, if you don't already have those services.
• Payments for a housekeeper or cleaning service during rental periods are part of doing business.
• You'll need funds set aside for a jump in unexpected maintenance and repair bills.

There are also a handful of potential one-time hits to your bank account. To spruce the place up for renters, for example, you might spring for painting the home's interior or exterior and for a face-lift on the landscaping. Other possible amenity outlays: new bedding, appliances, furniture and electronics.

Crucially, you may also need the help of a property manager to do things such as promoting the property to potential customers, coordinating with renters and service providers, and taking care of routine upkeep and maintenance. Management fees for these services can run between 10 percent and 30 percent of vacation rental income.

5. Understand tax implications on income property

The tax treatment for a mixed-use property is complicated. You should consult IRS publication 527 for details on how the tax rules apply to your situation, but here are two key concepts to understand:

When rental income must be reported

If you use the property as a vacation home yourself and rent it out for less than 15 days during the year, rental income from your vacation home does not have to be declared. Income from renting the place out for 15 days or more does have to be declared on your taxes, but it can be offset to some extent by expenses associated with renting out the property.

Which expenses can be deducted

When you both rent out your vacation home and use it yourself, how do you decide which expenses can be offset against your rental income?

The starting point is to determine whether your personal use is considered significant. Personal use is defined as the number of days when one of the homeowners occupies the property. This includes family members, unless they pay a fair rental price.

If the number of personal use days during the year exceeds the lesser of 14 days or 10 percent of the number of days the place is actually rented out, then you cannot deduct all the property expenses. You can only deduct the portion of property expenses equal to the number of days the property was rented out divided by the total number of days the property was in use, by you or others.

The above two principles are important, but the tax rules involving mixed-use rental property are very situation-specific and subject to change from year to year. Research them thoroughly before renting out your vacation home, and consult your tax advisor.

6. Factor in how your vacation rental home's value changes

Projecting your rental income, expenses and tax liability allows you to estimate the year-to-year amount you can expect to net from your vacation home, but there is another factor in making your vacation home turn a profit: the long-term increase or decrease in the property's value.

If you buy a property in good condition in a thriving area, the market value of that property may increase over time. That means even if you just break even on your rental income from year-to-year, that income is financing an investment that is growing in value.

In contrast, if you buy an aging property or one in an area that is on the decline, the market value of the property may decrease during the time you own it. Effectively, this decrease adds to the long-term expense of owning and maintaining the property and thus eats into your profit.

In either case, real estate markets are subject to many short-term fluctuations, so the impact of changes in market value depends greatly on how long you own the property.

Besides the financial factors involved in renting out your vacation home, there are steps you should take to depersonalize the home if you are going to rent it out to strangers. This includes removing family photos and valuable personal possessions, and making sure you don't leave behind any paperwork with sensitive financial information.

Profiting from renting out your vacation home takes some preparation, but if handled properly, the return on that investment can be positive.