The type of property you want to purchase affects the mortgage interest rate you can receive. 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 high interest rates and tax implications when purchasing additional properties.
Primary Residence
A primary residence is the main home someone inhabits. Your primary property can be an apartment, a houseboat or another form of property that you live in most of the year.
Primary residences tend to qualify for the lowest mortgage rates. For your home to qualify as your primary property, here are some of the requirements:
- You must live there most of the year.
- It must be a convenient distance from your place of employment.
- You need documentation to prove your residence. You can use your voter registration, tax return, etc.
There are some aspects of a primary residence 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. You can also claim your mortgage insurance payments if you purchased your home after 2006. 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 can classify one property as your primary 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 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 higher interest rate due to increased risk for the lender. Lenders will review your financials and evaluate your loan-to-value ratio, or LTV. Depending on the lender’s LTV ratio requirements, you may need to provide a large down payment.
On the other hand, neither of these things may happen – each situation is different. A second home must have the following characteristics:
- It must be a reasonable distance from your primary residence. Generally, lenders want it to be no more than 100 miles away.
- It must be exclusively under your control and not subject to a rental, time-share or property management agreement.
- You must live there. While someone other than you can also live in your home, some lenders may limit how long a tenant can live there as opposed to the owner.
The property must be accessible by car year-round. Although it’s cool, your Dr. Evil-style lair that’s built into the side of a volcano and reachable only by helicopter won’t qualify.
You can rent it out for up to two 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.
At Quicken Loans®, the property may qualify as a second home if it’s rented out for no more than 180 days in a calendar year. You must stay in the home for the larger part of the 180 days or for 10% of the days when you would otherwise rent out the home.
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 rented 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 time-share 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:
- The property can be a condo, house or a multi- or single unit.
- It typically requires a large down payment and more LTV restrictions.
- Mortgage rates tend to be a lot higher than for other properties, due to the higher risk the lender must take on.
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 the case. With the tax advantages that primary properties offer, the IRS wants to make sure to get a cut. If you decide you would like to move into your investment property, know that many property owners choose to complete 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, this is exchanging one rental for another.
This helps the owner minimize capital gains taxes and depreciation rapture taxes. To receive any gains exclusions, you must own the property for 5 years and live in it for 2. Then, the property owner can move into the property and start the process of converting the home into the primary residence.
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 to use the property.
Keep in mind, if you decide not to do a 1031 exchange, you may end up paying more capital gains and depreciation taxes. It’s important to work with a tax professional to help you determine the best strategy for your situation. Converting properties can be complex. Having an expert by your side will help you avoid penalties and additional tax burdens.
The Bottom Line
If you’re considering a purchase of additional properties, make sure it makes financial sense. Work with a tax professional and a lender to determine the best direction to pursue.
Are you considering the purchase of a property for a rental? What are some of the obstacles you have encountered? We want to hear from you. Please leave your comments below.
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