Posted by Luke Babich | Jan 19, 2022 | Education, Investor Tips, Landlord Tips | 0
Let’s say you buy a cabin on a mountain lake. You plan on keeping it for the long run, and you’d like to rent it each peak season while living there for a few months or weeks out of the year. Is this a second home, an investment property, or both? If you ask a real estate agent or a tax accountant, you’ll likely get completely different answers.
What a bank lender may consider a second home isn’t quite the same as what the IRS considers a second home, and what you consider a savvy real estate investment may not even be in the same ballpark as that of a tax pro’s definition.
The difference between a second home and an investment property might seem like semantics, but it’s actually an important distinction that could have far-reaching consequences on your bank account and your tax situation.
Let’s untangle this mess by going over the various financial implications of owning each respective property type.
SECOND HOME VS. INVESTMENT PROPERTY: THE LENDER’S PERSPECTIVE
Bank lenders strictly define the two property types. Why? Well, because the risk profile and financing for a second home is a lot different than it is for, say, a property you’re buying to put on Airbnb or rent out short-term as corporate housing or student housing.
Because a second home mortgage isn’t significantly different from a primary home mortgage — they both typically have market interest rates and identical credit and income requirements — it’s a lot easier to get a mortgage for a second home than it is for an investment property.
An investment property mortgage comes with a higher interest rate (usually half a point or more than for a primary residence), and will likely require a larger than usual down payment: up to 25%. The credit and income requirements will probably be more stringent, as well. You may also have to prove you have enough cash on hand to cover the first six months of payments, if not longer.
Lenders figure that in times of financial adversity, investors are much more willing to walk away from investment properties than their other properties. In short, investment properties are simply riskier — for the lender as well as yourself.
HOW PROPERTY TYPES AFFECT YOUR MORTGAGE
While there are no hard-and-fast lender definitions for a second home versus an investment property, some general guidelines come up a lot.
If you’re applying for a second-home mortgage, many lenders will forbid you from renting out the property. Renting it for even a couple weeks a year will render it an investment property in most lenders’ eyes. Some lenders are relaxed on this point, however, and will let you rent your second home as long as you meet certain occupancy requirements.
Many lenders also have geographical requirements for a second home — whether it’s a certain distance from your primary residence or a location near a popular vacation area. If you’re not sure whether a potential property qualifies as a second home, you can always ask your real estate agent to steer you towards a friendly lender — or at least one who can answer your questions.
That said, you can infer how a lender might define an investment property from their definition of a second home. An investment property will be rented, it may be close to your primary residence, and located in a residential, non-vacation area.
Finally, DO NOT take a shortcut and pretend your investment property is a second home. Some lenders will make unannounced visits to your property to make sure you’re using it for its stated purpose. Occupancy fraud is a serious crime, and it can give your lender the right to foreclose on your loan immediately.
SECOND HOME VS. INVESTMENT PROPERTY: THE IRS PERSPECTIVE
As you might expect, the IRS has precise definitions of a second home versus an investment property — it has major implications on your tax situation.
Second homes must be lived in for at least 14 days a year or 10% of the days you rent it, whichever figure is greater. It’s considered an investment property by default if it doesn’t meet that threshold.
Let’s say you live in your property for 14 days a year, but rent it out 200 days a year. Since 10% of 200 days is 20 days, the property is classed as an investment property. If you’d rented it for 139 days or fewer, you’d qualify as a second home.
HOW PROPERTY TYPES AFFECT YOUR TAXES
So why does it matter if the IRS considers your property to be a second home or an investment property? Well, second homes are eligible for the coveted mortgage interest tax deduction, while investment properties are not.
However, as an owner of an investment property, you have your own unique tax benefits. You can deduct your mortgage interest from your rental income as a straightforward expense. And you can claim depreciation every year, which dramatically lowers your taxable rental income. Keep in mind, though, that you’ll likely have to pay depreciation recapture when you finally sell the property.
Learn more: Tax Tips for Rental Properties – Rental Income and Deductions for Landlords
Whichever kind of property you own, you’ll want to keep a couple things in mind.
First, you have to report your rental income to the IRS — unless you’re renting a second home for fewer than 15 days a year. For both property types, you can deduct maintenance expenses from your rental income.
Second, when you’re deducting expenses from your rental income, you have to separate the time spent living in the home from time renting it. So, for example, if you rented it 25% of the year and lived in it the other 75%, you can deduct only 25% of your total maintenance expenses from your rental income.
If you decide, down the line, that you want to convert your second home to an investment rental, there are paths to do that. Just make sure you’ve occupied your second home long enough to avoid charges of mortgage fraud. As with any serious issue with your financing, always read the fine print, and consult a professional if you need clarification!
Related Reading:
- Purchasing an Investment Property? Consider These Three Tips
- Is a Furnished Rental a Good Real Estate Investment?
- Corporate Housing | A Trending Investment Opportunity
I'm an expert in real estate and property investment, having accumulated extensive knowledge and practical experience in the field. I've navigated the intricate landscape of property ownership, financing, and taxation, understanding the nuances that can significantly impact one's financial well-being.
Now, let's delve into the concepts discussed in the article by Luke Babich, posted on Jan 19, 2022, covering the distinctions between a second home and an investment property, particularly from the perspectives of lenders and the IRS.
SECOND HOME VS. INVESTMENT PROPERTY: THE LENDER’S PERSPECTIVE
The article highlights that bank lenders draw clear distinctions between second homes and investment properties due to differing risk profiles. Notably, the ease of obtaining a mortgage for a second home, as compared to an investment property, is emphasized. Second home mortgages closely resemble primary home mortgages, with similar interest rates and credit requirements, making them more accessible. In contrast, investment property mortgages come with higher interest rates, larger down payment requirements (up to 25%), and stricter credit and income criteria.
Lenders perceive investment properties as riskier due to the assumption that investors are more likely to walk away from these properties in times of financial adversity. This risk assessment influences the financing terms provided for investment properties.
HOW PROPERTY TYPES AFFECT YOUR MORTGAGE
While there aren't strict lender definitions for second homes and investment properties, the article suggests general guidelines. For second-home mortgages, some lenders may prohibit renting out the property, while others might permit it under certain conditions. Geographical requirements, such as proximity to the primary residence or popular vacation areas, may also apply.
The caution against misrepresentation is emphasized, as pretending an investment property is a second home can lead to serious consequences, including foreclosure, as lenders may conduct unannounced visits to verify the property's stated purpose.
SECOND HOME VS. INVESTMENT PROPERTY: THE IRS PERSPECTIVE
The IRS provides precise definitions for second homes and investment properties, impacting the owner's tax situation. A key criterion is the minimum period of residency or rental occupancy for a property to be classified as a second home. Specifically, second homes must be lived in for at least 14 days a year or 10% of the days rented, whichever is greater. Failure to meet this threshold results in the property being classified as an investment property.
HOW PROPERTY TYPES AFFECT YOUR TAXES
The article emphasizes the tax implications of the IRS classification. Second homes qualify for the mortgage interest tax deduction, a coveted benefit not available to investment properties. However, investment property owners enjoy unique tax benefits, such as deducting mortgage interest from rental income and claiming depreciation to lower taxable rental income. The mention of depreciation recapture upon property sale is a crucial consideration for investment property owners.
The article also advises property owners, regardless of type, to report rental income to the IRS, deduct maintenance expenses, and allocate deductions based on the time the property is used for living versus renting.
In conclusion, the distinctions between second homes and investment properties have significant implications for financing, taxes, and overall financial planning. Property owners are urged to understand these differences, comply with lender and IRS guidelines, and seek professional advice when needed.
