Where You Live: Primary Residence, Vacation Home and Investment Property, Defined

When you’re involved in the purchase of real estate, you’ll be surrounded by real estate professionals, lawyers and lenders using jargon that you might not be able to discern as a casual listener.

Learning how to navigate and understand real estate terminology will help you get the best mortgage interest rates and avoid a big tax bill when you sell.

Let’s get started with some basics. There are three potential classifications for the property: a primary residence, a secondary residence and an investment property. Understanding each classification can help you avoid unexpected high interest rates and tax implications when purchasing additional properties.

Primary Residence

To a lender, a primary residence is simply the home a buyer plans to inhabit most of the time after completing the steps of buying the house. You may also hear it referred to as a principal residence.

Your primary property can be an owned apartment, a single-family home or multiunit house or any other form of property that you live in most of the year.

Primary residences tend to qualify for the lowest mortgage rates because mortgages on these properties are among the lowest risk loans for lenders. For your home to qualify as your primary property, here are some of the requirements:

There are some costs of homeownership that are tax deductible. As of 2018, homeowners can deduct mortgage interest on loans up to $750,000. This amount can include primary and secondary residences. If you choose to include these deductions on your tax return, you will have to itemize your deductions instead of claiming the standard deduction.

You only can classify one property as your primary residence (your principal residence). If you’re married, you and your spouse must claim the same property as your primary home.

In addition, once you’ve bought the property, you must occupy it within 60 days following closing. If the loan originates through the Department of Veterans Affairs (VA), and you’re on active duty, your spouse can satisfy the occupancy requirement.

If you plan to turn the property into an investment or rental property within 6 months of closing, you must classify it as an investment property.

Secondary Residence

When purchasing a second home, you may need a higher credit score to qualify and you might receive a slightly higher interest rate due to increased risk for the lender. Lenders will review your financials and evaluate your loan-to-value ratio (LTV). Depending on the loan’s LTV ratio requirements, you may need to provide a large down payment.

On the other hand, it’s possible neither of these things may happen. Each situation is different and will depend on your financial situation.

There are several mortgage and refinance options available for second homes, but the property must meet the requirements to be eligible for these financing options. A second home must have the following characteristics:

You can rent it out for up to 2 weeks and keep the income tax-free. If you rent for 15 or more days, you’ll have to report the income, but you may be able to deduct certain things, such as rental expenses. It’s important to note that either your lender or the investor in your mortgage may place special limits on how often you rent the property.

Second homes also qualify for the mortgage interest tax deduction, although if you’re renting out the home, you have to be careful. In order to qualify for the deduction, you must use the home for more than 14 days or more than 10% of the days when you would normally rent it out, whichever is greater.

For example, if you rent out your home in Florida for 6 months – or about 180 days – between May and October (inclusive), you would still be able to classify your home as a second home for tax purposes if you stayed there for more than 18 days. That would be more than 10% of the days you rented it. A timeshare used in this way also qualifies for the tax deduction.

Investment Property

An investment property is a property you plan to use as a rental or to generate income. It has the following characteristics:

 

Investment properties can be the most challenging properties to finance. Guidelines for approving an investment property loan can vary by lender. It’s important to compare all your mortgage options and identify the best lender for your loan.

 

You must report all income generated from your rental property on your tax return. The owner may also deduct expenses such as the cost of materials to maintain the property, interest and taxes.

How To Convert A Property To Your Primary Residence

You may assume that to change your primary residence, you can simply move into your investment property or secondary home and call it a day, but that’s not always the case. With the tax advantages that primary properties offer, the Internal Revenue Service (IRS) wants to make sure taxpayers don’t claim a primary residence fraudulently.

 

Before moving into an investment property, you will need to contact your mortgage lender to see if someone is required to live in your current residence while you live in your rental. If so, you will need to find renters for the property. You’ll also need to talk to your attorney or financial professional to make sure that IRS rules are followed, or you could face a bigger tax bill.

 

But if you have time to plan ahead, you may be able to avoid paying extra taxes by completing a 1031 exchange. A 1031 exchange allows rental property owners to purchase another rental property with the proceeds from the sale of a previous rental, essentially exchanging one rental for another.

 

Why is this helpful? With a 1031 exchange, the property owner can minimize capital gains taxes and depreciation recapture taxes. To receive any gains exclusions, you must own the property for 5 years and live in it for 2 years, after which time you can begin the process of converting the home into a primary residence.

 

For example, let’s say you’re sick of the cold and plan to retire somewhere warm in a few years. In this type of situation, it may make sense to complete a 1031 exchange to trade your current investment property for a new property in your desired location. Then after a few years of operating the property as a rental, you’ll be able to move in and turn the home into your primary residence while minimizing tax costs.

 

If you decide to move into a rental property that was not a part of a 1031 exchange, you may end up paying more capital gains and depreciation taxes when you eventually resell the home. It’s important to work with a tax professional to help you determine the best strategy for your situation. Converting properties can be complex, so having an expert by your side will help you avoid penalties and additional tax burdens.

Mortgage Fraud And Your Primary Residence

You might be wondering at this point why any of these classifications matter? After all, you can say you plan on using a home as your primary residence when applying for a mortgage, and who’s to say your plans didn’t change afterward?

 

Unfortunately, that’s an example of mortgage fraud, and it can be prosecuted. Don’t take a chance on appearing dishonest with your lender or the government.

Don’t Confuse Primary Residence With Owner-Occupied Property

The federal government has an interest in expanding homeownership – a key method of building generational wealth in the U.S. – among low- and moderate-income earners, to support rural housing or as an important benefit of serving in our nation’s armed forces.

 

To this end, the Federal Housing Administration (FHA) offers mortgages at lower interest rates to those with lower incomes or shakier credit. The FHA doesn’t offer loans directly. Instead, it insures the loans that private lenders offer through the FHA, making them less risky to lenders.

 

Because this program is specifically designed for people looking for homes, it generally excludes investors from participating. The FHA, Department of Veterans Affairs (VA) and U.S. Department of Agriculture mortgages have owner-occupancy requirements that generally run between 1 and 3 years, depending on the program.

 

Government-backed mortgages do allow home buyers to purchase homes with up to four units and include future rental income in their applications. That’s because the government defines a single-family mortgage as a loan covering one- to four-unit properties. While most of us would consider a multiunit property to be an investment property, the government does not if the owner also lives there.

The Bottom Line: Understanding Primary Residence Requirements Can Help You Save On Your Tax Return

Tax law favors certain types of transactions, but in order to avoid problems with the IRS, you must follow its rules carefully and completely. Found a house you think might make a great primary residence, secondary residence or investment property?