Thinking of buying an additional property? It’s important to first understand the difference between a second home and an investment property. How you use the property will affect your mortgage rates and requirements, and your tax deductions.
What is a Second Home?
A second home is a property that you intend to live in for a part of the year. Typically, a second home is considered a vacation home. It is common among homeowners who frequently conduct business in different cities or states. Examples of second homes are vacation homes, single-property homes for work purposes, and pieds-a-terre. It’s worth mentioning that although it is called a second home, you can have several second homes.
How Does the IRS Define a Second Home?
The Internal Revenue Service (IRS) defines a second home as a property that is used by the homeowner for at least fourteen days a year or is used for 10% of the days that it is rented out. This means that if you use the home only during the summer break (June to September) but rent it out for the rest of the year (October to May), it still qualifies as a second home.
How Do Lenders Define a Second Home?
Mortgage lenders tend to have their own definitions of a second home. Some lenders require the second home to be located at least fifty miles from the owner’s primary residence. Others may require the home to be rented out for less than 180 days. To be certain if your property qualifies for second home financing, it’s best to check your lender’s requirements or ask your property manager to verify for you.
What is an Investment Property?
An investment property is used exclusively to generate income. It is not used as a residence for the property owner and his/her family but is instead rented out. These include rental properties such as multi-family units, condominiums, and townhouses. It also includes properties purchased with the intention of “flipping” them.
Are There Differences in Second Home and Investment Property Financing?
Mortgages for second homes and investment properties carry a higher risk than primary residences. This is because lenders expect that homeowners are more likely to pay for their primary residence than a property they’re not occupying. Hence, you can expect to pay higher interest rates and more stringent credit requirements.
In general, financing a second home is significantly easier than financing an investment property. There are mortgage lenders that offer interest rates that are comparable to the rates for primary residences.
However, what they do have in common is that mortgages for second homes and investment property will require you to make a down payment and cash reserves, and have good credit.
What Are the Key Differences in Mortgages for Second Homes and Investment Properties?
#1 Mortage Rates
Mortgage rates will be higher for investment properties. Lenders may charge 0.50% to 1.00% for an investment property, due to the risk that it carries. This is because property owners are more likely to “bail” on properties that they don’t consider as their home. Although investment properties aren’t necessarily disposable, it’s likely that they would rather put their money on the property that’s currently providing them with a roof over their head.
#2 Down Payments
Down payments for investment properties are higher than down payments for second homes. In most cases, the lender may require the buyer to pay a down payment that is equal to 20 to 25% of the property’s value. On the other hand, buyers for second homes may be required to pay only 10%. In comparison, the standard down payment for primary residences can be as low as 3.5%.
To qualify for financing on a second home, you will need to have enough income to cover the mortgage payments on your second home, as well as any of the expenses you may incur on your primary residence. Some lenders may need you to have a cash reserve that’s good for six months. This amount should be enough to cover the necessary payments for your second home and your primary residence.
#4 Rental Income
One of the benefits of owning an investment property is that you can invoke your anticipated rental against your debt-to-income (DTI) ratio. This means that you can take a percentage from your anticipated rent (usually 75%) and have it counted under your income requirement.
Keep in mind that if you’re planning on using the anticipated rent to qualify for a mortgage, you may have to perform an appraisal. In addition, you may be asked to demonstrate past property management experience.
Are There Tax Benefits for Second Homes and Investment Properties?
Rental income from an investment property is taxable income. Hence, it must be included in your annual tax returns. On the other hand, rental income from a second home does not have to be declared as long as your second home is rented out for less than fourteen days.
Investment properties can benefit from a variety of tax deductions, such as travel expenses, legal fees, repair expenses, and the like. However, second homes don’t get to enjoy these deductions, considering that they’re only allowed to be rented for a very limited time.
Can You Purchase a Home as a Second Home and Use It as an Investment Property Later?
The short answer is yes. However, you will have to inform your mortgage lender and the IRS. It is important to be as transparent as possible with regard to your intentions for your properties, or else you might find yourself in serious legal trouble. Mortgage lenders want to be certain that you’re using the property the way you originally intended to. If fraud is discovered, you may face hefty penalties — and even prison time.
Mortgage rates vary by lender and tax requirements aren’t set in stone. It’s important to consult a tax professional or lender to find out how you can get the best rates for your second home or investment property.
Luxury Property Care works with the best in the industry to provide our clients with sound advice regarding their investments. If you’re thinking of purchasing a second home or investment property, give us a call today. We would love to offer our expertise to help you obtain the right financing for your properties.