Second Homes vs Investment Properties: Mortgage Terms and Tax Rules

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A second home is a property that you intend to occupy for at least part of the year or visit on a regular basis. By contrast, investment properties are purchased primarily for income-generation and are often rented out for the majority of the year. When it comes to buying another house, whether that house will be considered a second home or an investment property could have big implications. Loans and taxes for these two property types are treated very differently, which makes it important for you to understand each designation as we’ve outlined below.

What is a Second Home?

A second home is an additional property that you purchase to live in, even if it’s only for part of the year. They're popular with older homeowners who want to purchase a vacation home after paying off their primary residence. To be considered a second home, it must be some distance from your primary residence, although this requirement may vary by lender.

Since there’s little reason to own a vacation property that’s near your primary residence, many lenders insist that a second home be at least 50 miles from your first home. Examples of second homes may include vacation homes, pied-a-terres, residences used for work or any other type of single unit property that isn’t subject to a timeshare agreement. For tax purposes, a home that you live in for at least part of the year and that is rented out for fewer than 180 days can be considered a second home.

What is an Investment Property?

An investment property is one purchased with the intention of generating income. You can live in an investment property, but most people choose to rent them out either as someone’s primary residence or vacation rental. Even if you intend to reside in the property yourself, any property that you’ll rent out may still be considered an investment property by lenders.

An investment property may come in the form of a rental, a property you intend to flip or even a commercial property. When it comes to taxes, an investment property is any property that is not occupied by the owner and is solely used for income generation. Any home rented out for more than 180 days per year is also typically considered an investment property.

How Mortgages Differ for Second Homes and Investment Properties

Lenders generally offer more lenient terms and lower qualification hurdles for second homes than they do for investment properties. For both second homes and investment properties, you’ll find that credit requirements will be more stringent than they are for loans on primary residences. We've outlined a few of the differences and similarities that you’ll see while shopping below.

Mortgage Rates

You can expect your mortgage rates to be higher for an investment property than a second home, all else held equal. Borrowers may charge anywhere from between 0.50% to 1.00% more for a mortgage on an investment property as they do on a second home. This is due to the greater perceived risk on investment properties, since people are considered more likely to ditch a business venture that’s become a financial hardship than a vacation home.

Both second homes and investment properties come with higher interest rates than otherwise similar primary residences; lenders generally see less risk in lending someone money for their primary residence because they’re less likely to bail on their payments when their living arrangements are at stake. By contrast, second homes and investment properties represent a higher risk for lenders, with borrowers more likely to walk away from payments on underwater properties, as demonstrated during the Great Recession.

Down Payments

Required down payments are higher for investment properties than second homes. To account for the additional risk banks believe they incur, they have the buyer assume a higher equity stake at purchase. While down payment requirements for second homes may be as low as 10%, lender requirements for investment property may mean the buyer will need to pay a down payment closer to 20-25% of the property value.

Simultaneously, down payment requirements will almost always be higher for second homes and investment properties than they are for primary residences, which can require down payments as low as 3.5% on an FHA home loan.

Qualifying Requirements

To qualify for a mortgage on your second home, lenders will want to see that you have enough income to cover the payments on your second home as well as the existing bills on your primary home. Some lenders may even require you to have enough cash in reserve to cover all the payments on both your properties for up to six months. The qualifications required for investment-property mortgages are similar, but may also require you to demonstrate a history of property management experience.

Both second homes and investment properties will have greater hurdles than primary residences. By contrast, underwriting requirements for your primary home are generous, and may even allow first-time homebuyers to finance part of their down payment requirements.

Rental Income

One benefit of investment properties is that you may be able to apply anticipated rental income toward your DTI ratio. If allowed, lenders typically allow up to 75% of the expected rents on your property to be counted toward your income requirement, which gives borrowers more wiggle room than they have with a second home.

However, using future rents to qualify for a mortgage requires additional paperwork and may require a specialized appraisal showing comparable rent prices for that property. You may also need to demonstrate previous property management experience for your lender to consider future rent as part of your income.

Is it Wrong to Claim Your Investment Property as a Second Home?

It's illegal to mislead your lender about whether your second property will be used to earn income. A common lie that homeowners make to mortgage lenders is to classify their purchase as a second home, when they actually intend to use it primarily for rental income. Intentionally misrepresenting the intended use of a property to obtain more lenient mortgage terms is called occupancy fraud and can lead to hefty fines.

Occupancy fraud may also put you in default of your loan agreement, which can mean forfeiting your home. Many high-tech lenders also now have access to digital verification processes that identify the most likely instances of fraud. Some mortgage companies will go so far as to schedule random site visits to verify who actually resides in the property.

Turning Your Second Home into an Investment Property After Closing

Sometimes borrowers may change their mind and decide to turn their second home into a rental property later on. Generally, it's not a good idea to change the occupancy status of your property within 12 months of your initial mortgage approval—this is a sure way to invite an investigation for occupancy fraud. However, there isn't much a lender can do if a homeowner decides to change their occupancy status a few years into the mortgage.

If you take this path, you will still need to report any new rental income to the IRS and make the necessary tax filings. You will also need to update your occupancy status if you ever decide to refinance your existing mortgage. It's a good idea to consult with a tax professional when deciding whether to change the occupancy status on a second home.

Tax Benefits of Second Homes vs Investment Properties

Rental income from your investment property must be included as part of your taxable income. By contrast, the rental income from a second home is exempt from this rule, provided that your property is rented out for 14 days or less.

For investment properties, you may be able to deduct any expenses that result from renting or maintaining the property. These deductions can be used to offset a portion of the rental income that you generate. However, second homes generally don't allow for the rental expense deduction, given the limited time frame in which they're allowed to be rented.

Second homes offer similar tax benefits to primary residences, which include deductible mortgage interest, property taxes and mortgage insurance payments. Owners of second homes should avoid tripping the 14-day threshold that requalifies the home as an investment-property, in the eyes of the IRS, especially if they wish to avoid reporting their short-term rental income.

Something worth keeping in mind is the change to the mortgage tax rules in 2018. Prior to 2018, mortgage interest on all properties, including primary residences, second homes and investment properties, was deductible for up to $1 million in mortgage debt. The 2018 tax rules drop the deductible mortgage debt amount to $750,000, although existing homeowners of properties purchased prior to December 15, 2017, are grandfathered in under the old law.

While the information above is accurate to our best knowledge, this article should not be construed as tax advice. Borrowers considering the purchase of an additional home should consult a tax professional.

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