Short-term rental platforms like Airbnb, VRBO, and HomeAway make marketing a vacation rental easier than ever. However, there’s a lot more that goes into running a vacation rental behind the scenes. Before buying their first short-term rental property, real estate investors need to understand the financial and legal side of owning a rental property.

The Income Potential of Short-Term Rentals

Short-term rentals are a growing segment of the real estate investment market, but are they really a smart investment? It depends.

Investors in cities like Nashville, Asheville, and Anaheim can see annual profits of $20,000 or more on a single short-term rental property. However, investors need to be smart when choosing a location for their purchase. In areas with jumbo home prices, like San Francisco or Santa Monica, rental rates aren’t high enough to net a profit. The key to vacation rental success is buying in an area with low home prices, low vacancy rates, and high rental demand.

Even within a city, home prices and rental rates vary by neighborhood. Investors should understand what travelers want when booking a short-term rental and work with a real estate agent to find the best area for their purchase.

Financing a Vacation Rental Purchase

Second homes require different financing strategies than primary residences, and financing is complicated further when buying an investment property.

In general, lenders want higher credit scores and larger down payments for vacation properties. You may have purchased your primary residence with as little as 3.5 percent down under an FHA loan, a popular option for first-time buyers without a lot of savings, but you can’t use it to purchase an investment property. Instead, you’ll need to apply for a conventional loan.

Down payments for second homes start at 20 percent, but some lenders require more. You can tap into your primary residence’s equity for the down payment via a home equity line of credit or cash-out refinance, but be cautious about putting your home on the line. When possible, cash is king for second home purchases; in fact, 42 percent of vacation rental investors pay cash.

Laws Restricting Short-Term Rentals

Cities are beginning to place restrictions on short-term rentals. Your city may require short-term rental permits, cap the number of short-term rentals, limit where they can operate, or restrict which types of properties can be used as a short-term rental.

Short-term rental laws are highly local and some cities are stricter than others. Before purchasing, familiarize yourself with local laws and any rule changes that are underway. Buying a property that complies with the law protects your ability to earn income from your investment.

Vacation Rental Taxes

Cities also collect taxes on short-term rentals, as do state and federal governments. Cities and states may levy lodging, occupancy, excise, and business taxes, while the IRS taxes rental income earned from your property.

If a property is used as a rental for more than 14 days in a year, property owners must pay taxes on the income, but they’re also able to deduct business expenses. Utilities, cleaning and maintenance, furnishings, property management fees, property taxes, and mortgage interest are all eligible business deductions.

When done correctly, vacation rentals are a great investment. Short-term rentals can earn up to three times what a traditional long-term rental makes. And while vacation rental properties cost more to operate, investors who buy in the right location and market their property effectively can net sizable profits from a short-term rental. When you’re ready to buy, talk to a real estate agent to find a property that’s a smart investment for you.