Second Home vs. Investment Property: What’s the Difference?

Second Home vs. Investment Property: What’s the Difference?

I get asked this question a lot….

Strictly speaking, a second home is a property that you intend to occupy for 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.

There are several significant differences between a second home and an investment property. Find out what you need to know before diving in.

If you buy a mountain house and then use it yourself some of the time and rent it out when you aren’t there, is that second home or an investment property?

These terms matter because there are tax and lending implications for both second homes and investment properties, so you need to know how they might apply to you.

With that in mind, here’s the short answer when it comes to the difference between these two terms, and why it matters when you’re buying a property that isn’t going to be your primary home.

The short answer
If I had to define the term "second home" in one sentence, I’d say that it’s a property that you plan to live in for part of the year, while simultaneously maintaining a primary residence elsewhere. Here are two scenarios:

  • Your primary residence is a house in a suburban area and you buy a condo at Lake Dillon, CO to use for three consecutive months each summer. The property is available for your personal use at all times and is never rented.
  • You decide to buy a home in your favorite vacation destination. You use the home for two weeks each winter for your ski vacation but rent it out on a weekly basis for the vast majority of the year.

Here’s the point. Both of these could be considered second homes, although they are used in completely different ways. It’s also important to realize that the word "second" can be misleading. It’s possible to have a primary home and several "second homes."

Second home and investment property financing methods are different

Here’s why the financing issue is so important. It’s generally much easier to finance a second home than an investment property. You can typically find a second home mortgage with an interest rate that’s comparable to market rates for primary residences, credit qualifications are generally similar, and as long as your income justifies both mortgages, a second home loan is a pretty straightforward process in most cases.

On the other hand, investment property mortgages are typically more difficult to qualify for and are more expensive. Lenders often have higher credit score requirements when it comes to investment properties, and also generally charge higher origination fees.

Having said that, there are some advantages when it comes to qualifying for investment property financing. Unlike with a second home, you might be able to use some of your anticipated rental income to help you qualify for an investment property mortgage. In fact, you can find some lenders that aren’t even concerned with your other debts as long as the property is expected to generate enough cash flow to cover its expenses.

Mortgage rates are higher for second homes and investment properties than for the home you live in. Generally, investment property rates are about 0.5% to 0.75% higher than market rates. For a second home or vacation home, they're only slightly higher than the rate you'd qualify for on a primary residence

Second home vs investment property: The IRS definitions

As far as the IRS is concerned, you can consider a property to be a second home if it meets a certain owner-occupancy threshold. Specifically, if you use the home for at least 14 days each year or 10% of the days you rent it out, whichever is greater, it can be considered a second home for tax purposes. If it doesn’t meet the appropriate minimum, it is considered an investment property.

Here’s an example: Let’s say that you rent your vacation home for a week at a time, and that it ends up renting for 40 weeks in 2018. This translates to 280 rented days, so if you personally use the home for at least 28 days, you can treat it as a second home. If you use the property for 27 days or fewer, it is officially an investment property in the eyes of the IRS.

It’s also worth mentioning that if you rent your second home for fewer than 15 days in a year, the IRS doesn’t require you to report any of your rental income. Even if you make thousands of dollars, the IRS isn’t concerned with your rental income unless your property is rented for more than two weeks.

Is it a Rental Property or Second Home?

You can rent your second home out for as many as 14 days a year and pocket the income without turning it into a rental property for tax purposes. If you use your second home as both a rental and for personal purposes, you can allocate your deductions between two categories: if you spend 20 days a year in a property that you rent out for 80 days, the IRS treats it 20 percent as a second home and 80 percent as a rental property.

Tax Treatment of Second Homes vs Rental homes

Second homes generally get treated the same way as your first home. If you can write off the property taxes from your first home, you can write off the property taxes from your second home. The same rule applies to your mortgage interest and to the limits that the IRS imposes. You can write off the interest of up to $1 million in mortgage debt that was incurred on buying property or on improving it. You can also write off the interest on up to $100,000 of "home equity debt," which is debt placed against your first or second homes for anything other than buying them or improving them. These limits are not imposed on a per-home basis, but on an overall basis, so if you owe $1.3 million between your two homes, you can only writ Tax Treatment of Rental Homes.

Rental homes are treated as investment real estate. You report your income and expenses from your rental homes on the Schedule E form which lets you deduct just about every expense that you incur in owning the property. You pay taxes on the profit that you earn on the home after expenses. If you lose money on the home, you can use that loss to offset income from other investment real estate properties or claim up to $25,000 of the loss against other income. To be able to fully claim this "passive activity loss" against your income, you will need to have an Adjusted Gross Income of $100,000 or less, since the ability to carry that loss forward goes down by $1 for every $2 of income over $100,000 and is completely phased out on incomes of over $150,000.

Selling a Second Home

When you sell your second home for a profit, you pay capital gains tax on your profit. The way around this is to turn your second home into your primary residence. If you can do this, you shelter a portion of your gains from capital gains tax.

Selling an investment/ Rental Home

When you sell a rental home, you pay capital gains taxes on the gain unless you plan to reinvest the funds into other investment property. If you intend to do this, you may be able to do a Section 1031 tax deferred exchange where, if you follow IRS rules, you can defer paying capital gains taxes.

The Takeaway

The bottom line is that if you plan to use the home you’re buying for at least two weeks per year for your own occupancy, it can be considered a second home. For example, even if your primary motivation for owning a property is to generate rental income, but if plan to use the home personally for a few weeks each year, technically enabling second-home classification.

The distinction is important when it comes to financing and tax implications, so be sure that if you plan to use "second home" financing that you meet your lender’s definition of a second home. And be sure to check with a qualified tax professional who can tell you exactly how to treat your rental income and how to handle other tax considerations before you start your tax return.

Another great article on the subject: Sell or Rent My House

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