Many people have properties in tourists’ attraction spots. They enjoy these houses for a few weeks every year and sometimes use them as rental places to earn extra income during the peak season.
What will you call these residential units a second home or investment property?
People usually get confused and use these terms interchangeably. It is very important to understand the difference as it may affect your bank account and your tax profile. Let’s try to find out from different perspectives and different financial implications associated with it.
Lender's viewpoint about a second home and investment property
Banks are the lenders for most people, and these lending agencies have different definitions for both these terms. Financing for a second home is different than financing an investment property. The residential unit to list for short-term or long-term rental business will be considered an investment property.
It is important to understand that a second home's mortgage is almost like a primary home. Income requirements and credit score are almost the same for both, and the interest rate is also the same. If you will look in detail, getting a mortgage for a second home is easier than investment property.
The interest rate is high for the investment property mortgage, and you have to pay a larger down payment as well. In some cases, a down payment can be as high as 25% of the total value of the property. Income requirements and credit scores will also be tougher. Make sure you have almost six months of installments to be on the safe side.
Banks understand that if the property owner faces some financial problems, they will sell the investment property first. So, lenders consider these properties risky and want to protect their interest with a high down payment and credit score.
Effect of property type on mortgage
Banks have not defined second home and investment property properly. But some general guidelines are very common in this regard.
If you already have a primary home and apply for the second one, banks will not allow you to rent out this second property. If you rent it out even for a week or so, it is well considered an investment property. However, some lending agencies are not very strict if you meet their few occupancy requirements.
Some lenders give importance to the location of the second property if this property is near your primary home or at a vacation destination. If you are confused about the status of the property you want to buy, you can get help from real estate agents. They can guide you about the requirements of different lenders, and you can choose the most suitable one. You can compare the requirements of different lenders and choose the one which suits your needs.
Try to find the definition for a second property; different lenders define the term differently. You can rent out your investment property, and it must be located in a residential area. The area should not be close to a vacation destination, and it can be close to your primary home.
However, you have to be very careful and honest. Don't try to mask your investment property with a second home. Lenders can visit the property without telling you to make sure that you are using the property for the purpose you have mentioned. If they find the use is other than the mentioned one, it will be considered occupancy fraud. In this case, the lender will have the right to foreclose your loan as soon as they finds it.
IRS viewpoint about a second home and investment property
IRS has defined the second home and investment property very precisely because it can affect your tax profile.
A residential unit classified as your second home, you have to live there for 14 days a year. If you use it as a rental property, you have to live there for the 10% of the days. For instance, if you rent out the property for 100 days, you have to live there for 10 days. If you do not fulfill this condition, the property will be ranked as an investment property.
Relationship of property type and taxes
Many people don't understand why it is important to differentiate the two terms. It affects the percentage of tax you have to pay. If the property is the second home, you will be eligible for certain tax deductions, but if the property falls in the category of investment property, there will be no tax deduction.
On the other hand, you can enjoy some tax benefits as an owner of an investment property. For instance, you can add mortgage interest to rent, as it will be categorized as a straightforward expense. Moreover, you can also claim depreciation, reducing your taxable rental income. However, keep in mind that when you sell the property, you have to pay the depreciation.
If you have a second home or an investment property, you must consider a few things.
Declare your income from this property to IRS if you are using it for rental purposes. If you rent out the unit for less than 2 weeks a year, this declaration is not required. You can deduct property maintenance charges, no matter, it's your second home or investment property.
Secondly, if you are using the property as the rental unit, you can deduct maintenance charges for only the period for which it was on rent. If you live in the house for 50% of the days and 50% of days it was rented out, you can deduct the maintenance charges for 50% of maintenance cost only.
Occupy the second home for a longer period and avoid mortgage fraud allegations. To avoid any serious tax issues, it's better to consult a professional lawyer who is well aware of these problems. Moreover, try to clarify everything before buying a property and applying for a mortgage. Clear the status of the property well in the beginning to avoid any further problems.