Second Home or Investment Property! What's the difference?
A lot of the time, people use the terms "second home" and "investment property" to identify a dwelling that isn't their primary residence pretty much interchangeably. However, there are some very real differences between the two.
An investment property is defined as a property that is not the owner's primary residence, and is used to generate income, enable the owner to take advantage of tax benefits, or profit from appreciation. In short, if you're buying real estate with the intention of earning a profit from it as opposed to living in it, then it is, by definition, an investment property.
An investment property can be a commercial property, a residential property from which you're earning rental income, or a property that you've purchased with the intention of re-selling it for a profit.
What this means to you in terms of a mortgage is that you will be expected to make a bigger down payment than you would if you were buying a second home, and that your mortgage will most likely have a higher interest rate.
A second home is a residential property that you will be occupying for part of the year, in addition to your primary residence. Usually, a second home is a vacation house or cottage, but it could also be something like a condo in the city that you use when you're there on business. Sometimes, you can't get a second home mortgage for a property like a city condo. Some lenders expect it to be located in a vacation or resort area (think oceanfront, or secluded cabin). Always, it has to be at some distance from your main residence.
Second home mortgage rates are lower than an investment property. The mortgage will be typically accompanied by what is known as a "second home rider," which is a statement to the effect that you will use it only as your second home - not as a timeshare or a rental - and that no other person will have control over the occupancy of the home.
Will Lenders Consider the Loan an Investment Loan or a Second Mortgage?
If you are buying a second home in Orange County, California, you will not be able to take out a second home mortgage if you intend to rent the property for any length of time. You could, for example, get a second home mortgage for a summer cottage, but you won't be able to rent it out during the winter. If that is your intention, then you may apply for investment property loans.
You might think that you can benefit from the lower rate attached to a second home mortgage, and then just do as you please for the rest of the year, but it's really not advisable. In this day and age, there's not much that's easily hidden. You have to pay income tax on money you earn from rentals, and that immediately makes the property identifiable as an income property or investment property.
A reputable lender will not encourage you to take advantage of the lower rates available for second homes if you intend to earn income from the property. Besides, as the owner of an investment property, you will be eligible for various tax benefits not available to owners of vacation homes, and that can go some way to offsetting the higher mortgage rates on an income property. Generally speaking, it's best to keep it all above board.
Wait, what if I live in my Rental Property or my Second Home some time in any given year?
If you plan not to rent out a property and use it for personal reasons other than your primary residence, then such property would be considered a second home. However if you never live or vacation in a property, but hold it for investment purposes, it would be considered an investment property.
The IRS gives you a bit of a leeway. For instance, for tax purposes, you can rent out your second home for 2 weeks/year pocketing some income without considering it a rental property. Conversely, if you had to live in an investment property while performing some repairs or improvments, the IRS doesn't consider those days to be personal use. If you use a rental property for personal purposes, you can allocate it between the two categories, as well. For example, if you spend 50 days a year in your investment property that you rent out for 100 days, the IRS treats it 50% as a second home and 50% as an investment property.
The IRS requires you to split your use out if you rent out a property for more than 2 weeks/year that you also use for personal purposes. You split it by combining the number of days rented out with the number of days you lived in excluding days in property while improving it. Determine proportional share of rental days and the share of days used for personal purposes, then use thosecentages to allocate costs. So, if you use the property 20% of the time, you can claim 20% of the mortgage interest and property tax as a personal deduction. You also get to claim 80% of the property's expenses as expenses to offset investment income on your Schedule E. In this case, there's a drawback to a dual use property, if you lose money on it and you spend more than 2 weeks/year or 10% of the time that it is "used", you can't use any loss on the property to offset other income.
Ok, How About Tax Treatment of Second Homes?
When it comes to tax purposes, Second Mortgages generally get treated the same way as your first home. You can write off property taxes from your first home, and the same goes for your second home. The same guideline and rule applies to the interest on your mortgage and to the limits that the IRS imposes. IRS allows you to write off the interest of up to $1M in mortgage debt that was incurred on buying your property or on improvements. You can also write off the interest on your mortgage up to $100K of "home equity debt", which is the debt put against your first or second homes for anything other than buying them or monies spent on improving them. These limitations are not imposed on a per-house basis, but on an overall basis. For example, if you owe $1.5M between 2 homes, you can only write off the interest on your first $1M in mortgage debt and $100K in home equity debt.
What About Tax Treatment of Investment Properties?
Since rental homes are treated as real estate investment, there is no limit as to how much interest you can write off. You report your investment income and expenses on Schedule E form which lets you deduct just about every expense that you incur in owning any investment property. Keep in mind, you'll have to pay taxes on profits you earn on rental homes after expenses.
If you lose money on your rental home, you can use the loss to offset income from other real estate investment properties or claim up to $25K of the loss against other income. Bare in mind, you'll need to have an Adjusted Gross Income of $100K or less to be able to fully claim this "passive activity loss" against your income. Since the ability to carry that loss forward goes down by $1 for every $2 of income over $100K and is completely phased out on incomes over $150K.
Selling Your Second Home
When you sell your second home for a profit, you will have to pay capital gains tax on such profit as the IRS's capital gain exclusions can't be carried forward to second homes. The good news, there's a way around this, turn your second home into your primary residence. By doing this, you will be able to cover a portion of your gains from capital gains tax. The process to do this is complicated, Arbor recommends you to consult wi your accountant to help you minimize your taxes paid when selling your second home.
Have more questions about Second Home versus Investment Property? Arbor has a network of accountants we can recommend, please contact us should you need a tax advise!