Second Homes vs Investment Properties: Mortgage Terms and Tax Rules

Second Homes vs Investment Properties: Mortgage Terms and Tax Rules

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A second home is a one-unit property that you intend to live in for at least part of the year or visit on a regular basis. Investment properties are typically purchased for generating rental income and are occupied by tenants for the majority of the year. There are significant differences in the costs and loan qualifying requirements between a second home and an investment property which you should understand before buying another house.

What is a second home?

A second home is a property you purchase in addition to your current home to live in for part of the year. Lenders may require proof the property is at least 50 miles from your current residence to be considered a second home. Examples of second homes include:

Lenders consider a property a second home if it is a one-unit property that isn’t subject to a timeshare requirement. The IRS defines a second home as a property you live in for more than 14 days per year or 10% of the total days you rent it to others.

What is an investment property?

An investment property is a residence purchased to earn rental income or flip and sell for a profit. Unlike second homes, an investment property can be more than one unit: two- to four-unit investment properties allow you to earn income from multiple tenants. An investment property may also be a commercial property.

Building an investment property portfolio allows you to build equity in real estate using the rent collected from tenants. This can be a great long-term wealth strategy

How mortgages differ for second home and investment properties

It’s generally cheaper and easier to get approved for a second home mortgage versus an investment property loan. Lending requirements for both types of properties are more stringent than they are for primary residences.

Mortgage rates

"Occupancy" can have a major impact on the mortgage rate you’re offered. There are three types of occupancies related to mortgage lending: primary, second home and investment. Lenders usually charge higher interest rates for second homes and investment properties, due to the risk that borrowers can walk away from these types of properties.

Homeowners will prioritize their primary homes if hard financial times hit, and lenders may mark up your interest rate by 0.50 to 0.875 percentage points higher than a primary residence. If you’re making a low down payment with a low credit score, the rate difference could be even higher.

Down payments

Lenders require a higher down payment for investment properties than second homes to compensate for the extra risk of default. The typical minimum second home down payment is 10%.

Lenders may require a 15% to 20% down payment for a single-family home investment property purchase. If you’re buying a two- to four-unit multifamily investment home, you’ll need to save up to 25% for the down payment.

Homebuyers who are willing to live in one unit of a multi-family home for at least 12 months may qualify for a loan backed by the Federal Housing Administration (FHA) with as little as 3.5% down. An added bonus: The income from the rented units may be used to qualify. The U.S. Department of Veterans Affairs (VA) guarantees no down payment loans for eligible military borrowers to purchase properties with up to seven units as long as the borrowers live in one of the units.

Qualifying requirements

Lenders typically set a higher bar to qualify for a second home or investment property mortgage than a primary residence. Many lenders require a minimum credit score of 720 for a second home purchase and 700 for an investment property if you’re making the lowest down allowable down payment. They may even require you to have enough cash to cover the payments on the home you’re buying for up to six months.

You’ll need to prove you have enough income to pay two house payments for a second home or investment property. In most cases, the rental income on an investment property can’t be used to qualify unless your tax returns show you have property management experience.

Rental income

You may be able to add up to 75% of the expected rental income to offset the mortgage payment on the investment property you purchase. However, lenders that offer this option may require a specialized appraisal that analyzes comparable rent prices in your area.

The extra appraisal requirement makes an investment property appraisal more expensive than a regular appraisal. You may also need to prove you’ve managed rental properties in the past for the lender to give you credit for potential rent income.

One exception to this rule is the FHA loan program. FHA guidelines allow FHA-approved lenders to apply anticipated or actual rental income on a two- to four-unit property to your total income, even if you have no landlord experience. You must live in one of the units at least 12 months to be eligible for this financing option.

Is it wrong to claim your investment property as a second home?

It may be tempting to claim you’re buying a home as a second home when you intend to rent it out to avoid a higher interest rate and down payment requirements. However, lenders consider this "occupancy fraud" and it could lead to an FBI investigation and hefty fines.

You’ll typically sign an "occupancy affidavit" at closing, which gives the lender the right to foreclose on your loan if they discover you intentionally misrepresented the use of your property. Many mortgage companies use high-tech digital verification systems to search for evidence of mortgage fraud. Others schedule random site visits to confirm who is actually living in the home.

Turning your second home into an investment property after closing

It’s not uncommon for someone to decide to convert a second home to an investment property at some point. It’s best to read your mortgage paperwork to verify there aren’t any restrictions on how long the home has to be used as a second home to avoid an investigation for occupancy fraud.

Don’t forget to report rental income to the IRS when you file taxes. If you decide to refinance, you’ll be subject to investment property guidelines and interest rates on the new mortgage. That means you’ll need more equity to refinance and will likely pay a higher rate than you did when the home was classified as a second home.

Tax benefits of second homes vs. investment properties

The tax benefits of a second home are very different from those associated with an investment property. The table below shows important differences:

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Tax benefit
Second home
Investment property
Expense write offGenerally not allowedCan write off mortgage interest, maintenance, utility bills and depreciation
Mortgage interestDeductible along with property taxes, and mortgage insuranceDeducted from rental income as part of expense write offs
Rental incomeNot usually taxable if property is rented less than 14 days per yearMust be reported if property is rented more than 14 days per year

One important reminder about the 2018 tax rule changes: You can only deduct mortgage interest for up to $750,000 worth of total mortgage debt, including loans on primary residences, second homes and investment properties. However, that limit increased to $1 million if the property was purchased prior to Dec. 15, 2017.

It’s always best to consult with a tax professional to get tax advice to maximize the tax benefits of your second home or investment property.

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