If you’ve compared mortgage rates for buying a second home or investment property, you’re already on a promising path: either you’ll have a place to go for vacation, or you’ll have a place that’ll generate income and put more money in your pocket.
Either way, the ability to own more than one property is an enviable position, but how you classify that property makes a difference in how much you’ll pay to finance and own it.
Secondary residence vs investment property
Are you buying a second home or making an investment?
This can be confusing, especially if you plan to occasionally rent out the property – using it regularly for vacations, for example, but also making it available on Airbnb for a portion of the time you’re not using the property and living. instead in your primary residence.
However, making money from your property does not automatically make it an investment. The precise definition of property depends on how much time you spend there.
Elliot Pepper, co-founder, certified financial planner and tax manager at Northbrook Financial in Baltimore says you need to be careful of what he calls “the 14-day limit rule.”
“Very generally speaking, if you personally live in your second home for 14 days or less – or less than 10% of the days it is rented out – in a year, then it would be considered rental property and the income earned would be taxable. says Pepper, “but you would also deduct expenses associated with the property.
On the other hand, if you use the property for more than 14 days or more than 10% of the rental time, any rental income you receive is not taxable, but you also cannot deduct expenses, said Pepper.
In general, a second home is like a vacation home – a home you buy for your enjoyment and live in for part of the year. In contrast, an investment property is a property that you plan to rent out for the purpose of generating income.
Different lender requirements
Distinguishing between a second home and an investment property is important not only for tax purposes, but also when looking for home financing.
Julienne Joseph, assistant director of government housing programs at the Mortgage Bankers Association, explains that credit score and loan-to-value ratio requirements vary depending on what the buyer plans to do with a property.
“Investment properties generally have stricter underwriting guidelines than second homes and primary residences because there is an assumption [greater] risk of default on properties that borrowers do not occupy,” says Joseph.
In other words, if a borrower is struggling to make their mortgage payments, they are more likely to keep up with payments from their primary residence, which they live in more often, than payments from a second home – a more risky for lenders.
Part of the stricter standards for an investment property might include a higher down payment requirement.
For example, the Navy Federal Credit Union requires a 25% down payment for an investment property, but if you’re considering a second home, the down payment can be as low as 5%.
That’s a huge difference: for a home with a closing price of $500,000, second home buyers may be able to put down just $25,000 (or 5%), while homeowners investment properties should find $125,000 (or 25%).
Different mortgage rates
While you may have read about the lowest mortgage rates, these headline-worthy financing options generally don’t apply to second homes or investment properties.
“Buyers may find that current rates for second homes and investment properties are lower than in previous years, but on average they will likely be higher than those offered to borrowers who actually occupy their properties,” Joseph says.
Different results at tax time
What are the tax implications of a secondary residence compared to an investment property?
Homeowners benefit from the ability to deduct mortgage interest, but Pepper points out that it can get a bit tricky if you own a second home, due to the $750,000 total debt limit for interest deductions. Essentially, if you have more than $750,000 in mortgage debt between the two properties (or more), you’ve maxed out the amount you can use to deduct interest.
For an investment property, however, the rules are different.
“Interest on a mortgage linked to an investment property is fully deductible [Form 1040] Schedule E for a taxpayer and therefore can be used to offset any income generated from the property,” explains Pepper.
In addition to deducting mortgage interest, owners of investment properties benefit from the ability to deduct a wide range of expenses. The IRS indicates that the following costs are deductible:
- Property taxes
- Advertise the property to attract tenants
- Materials and supplies used for property maintenance
If you also hire someone to do the work, such as a carpenter or electrician, you can deduct their salary. However, you are not allowed to deduct the cost of a renovation to improve the property.
Opposed to improvement, Pepper says investment property owners can also use depreciation to their advantage.
“For a personal residence, the owner is not allowed to deduct the actual cost of the home for tax purposes,” Pepper explains. “However, for an investment property, the taxpayer will be able to benefit each year from a deduction for depreciation. This deduction is based on the price of the house purchased and will be used to offset any income from the property.
Pepper notes that this deduction is not a permanent write-off, “because the amount of depreciation taken will reduce the base of the home. When the taxpayer goes to sell, they may end up with a larger tax gain that year. That’s a big point of differentiation.
Additionally, whenever the year of sale arrives, an investment property owner may be subject to income tax if the sale results in a profit, Pepper says.
Can an investment property be called a second home?
Tempted to call your investment property a second home and enjoy some of the benefits of a second home, like a down payment and lower interest rate?
Do not be. In the world of mortgages, you have to call it what it is – whatever “it” may be.
“It is absolutely imperative that borrowers be completely transparent when disclosing the intended use of the property to their lender to ensure they receive the correct product and rate,” says Joseph.
Joseph adds that borrowers may be asked to sign a document certifying the intended use of the property, so they will need to put in writing what they plan to do with the house. Misleading a lender otherwise could have serious consequences.
“Intentionally misleading a lender is mortgage fraud,” says Joseph. “Not only is it unethical, it’s illegal and could result in criminal charges.”