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Dangerous Waters

Now might be the time to pick up a vacation home. But be careful out there.

By Deborah Orr
Forbes Magazine
June,  200

It's a great time to buy the vacation home you've been dreaming of, that retreat by the sea or in the woods you might retire to some day. Mortgage rates are low, prices are down and the bulge bracket of people aged 44 to 62 will presumably resume shopping for retirement retreats very soon.

It's also a terrible time to buy. Shorelines are disappearing, and tax-hungry locals are putting the squeeze on second-home owners. Worse, prices in certain overbuilt Sunbelt areas, such as Phoenix-Mesa-Scottsdale and parts of Florida, will fall another 20% or more and won't begin to recover until 2011, Moody's (nyse: MCO - news - people ) predicts.

Buy for the long haul. Stick to stable markets. Follow these tips.

Avoid golf subdivisions. Water frontage and mountain views have one thing in common: scarcity. But if a new community's main selling point is a golf course, be wary. There can always be another golf course development. Mesa, Ariz. has 100 golf courses within a 20-mile radius. "People want the green, but it doesn't have to be a golf course," observes John McIlwain, a senior fellow at the Urban Land Institute. Bike trails and hiking paths are now more of a draw for both second-home buyers and new retirees, he says.

Think like a boomer. Right now folks are staying put, reluctant to sell their homes in a down market. But over the longer term, predicts demographer William H. Frey of the Brookings Institution, people born between 1946 and 1964 will continue to flock to exurbs of cities such as Austin, Atlanta, Dallas and Las Vegas, along with smaller metro areas such as Santa Fe, N.M. and Boise, Idaho. They want urban cultural amenities nearby, plus mountains and streams outside their back doors.

Take account of taxes. State and municipal governments have been shifting the property tax burden to part-year residents, mainly through "homestead" exemptions and caps on increases in property tax assessments that protect only full-year residents. That's a particular problem in states that don't impose income taxes and so rely heavily on real estate levies. In Florida, a snowbird might pay ten times as much in property tax as his full-year neighbor, reports Dominic Calabro, president of Florida TaxWatch. With property values falling and voters restless, it could get worse.

On the other hand, if you plan to retire to a second home soon, an income-tax-free state can be a lure. Warning: If you move to Florida but keep a pied--terre in New York City, the northern revenuers might come after you, insisting that you've never moved. So register to vote and apply for a driver's license in Florida and spend more than half your time down south.

Consider the commute. Last year a third of second-home buyers stayed within 100 miles of their primary residence, according to a National Association of Realtors survey. With traffic getting worse and gas prices rising, proximity could prove even more important to future appreciation--to say nothing of your own enjoyment. If you're considering a vacation home to which you (or visiting grandkids) must fly, look for one served by multiple carriers or airports. Mount Hood, Ore. has mountain views, a community of outdoor sports enthusiasts and the Portland International Airport, served by ten carriers, just 75 miles away. Seattle-Tacoma International Airport is a 225-mile drive.

Widen your horizons. If you fall in love with a place that's still too expensive, take a look at nearby areas--provided they're not glutted with new development. Example: St. Michaels, a quaint bayside village in the Chesapeake region of Maryland, boasts restaurants, shops, homes built in the 1800s and Vice President Dick Cheney as a summer resident. Three-bedroom cottages with a sliver of land sell for more than $500,000, and prices are down just a bit. But in nearby Royal Oak, you can get a refurbished 1920 farmhouse for $359,000 or buy a waterfront lot and build. Like St. Michaels, it's an easy drive from Washington, Baltimore or Philadelphia. Royal Oak's shallow waterfront offers kayaking, crabbing and fine views.

Go for slow growth. Prices in California's Napa Valley, with its rolling hills, vineyards and access to San Francisco, are down to 2004 levels. Moody's predicts a further 10% decline in 2009. But land-use restrictions mean there won't be lots of new construction to hinder a strong recovery after that.

In Charlevoix, Mich., a century-old summer resort on the shores of Lake Michigan, a foot of lake frontage goes for $5,000, down from $7,000 two years ago, reports Loren Musilek, a Realtor for Prudential. Michigan's economic problems will continue to weigh on prices, so don't look for a quick flip. Still, the area isn't plagued by foreclosed and empty units, as some new, overbuilt Sunbelt resorts are.

Watch water levels. On the East Coast, sea levels are rising, washing away beach land and driving up insurance costs. In some areas, projects to protect dunes mean high tax bills. Out West, the problem is usually too little water. Check water rights before making an offer on a ski lodge in the Rocky Mountains or in a desert area, says McIlwain of the Urban Land Institute. The Colorado River is "oversubscribed," as are other rivers in the Southwest. "If the water table is being depleted, your well could run dry," he says.

Make a big down payment. Lenders are particularly skittish now on second homes; a big down payment should help you snag a better interest rate. Don't fall into the trap of taking a big mortgage against your paid-up first house to buy a second one. Interest on up to $1 million in total mortgage debt (for a first and/or second home) is deductible, but only if the loan is used to buy or improve the house securing it. A separate tax code provision allows you to deduct interest on up to $100,000 of home equity loans for any purpose, including buying a second home. But this interest deduction isn't allowed in the alternative minimum tax.

Check rental potential. If you're years away from retirement, you may want to scope out the rental appeal of any vacation property you buy. Just don't count on rental income to make the monthly payments, warns James Lund, a financial adviser at Ameriprise in Minneapolis. "The rent is icing," he says. If you are buying a condo or a house that is part of a neighborhood association, be sure to check rules that might restrict rentals. Consult your accountant on the best way to handle the tax issues. It's complicated, but often you'll do best by treating the property as "mixed use." Otherwise you must limit either your own stays or your paid rentals to two weeks a year.

Play vulture with care. Do you want to speculate on the hardest-hit markets? In Naples, on Florida's Gulf Coast, prices are off 27% and still falling. "I am getting calls from buyers saying, 'Hi, I'm a vulture.' People are looking to steal things," says Connie L. Gustafson, an agent with Prudential Florida wci Realty in nearby Fort Myers. The sellers of a quarter of the houses now on the market there owe more on their mortgages than their houses are worth. Lenders must approve these "short sales" and are holding up transactions, sometimes for months, she says. If you do play vulture, avoid properties--such as new condominiums or developments with lots of amenities run by a homeowners' association--where defaults by others could jeopardize the upkeep of your own property.

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