Requirements, Tax Implications, & Proper Classification of Second Homes & Investment Properties

Are you in the market to buy a second home or an investment property? If so, then it is important to know how you will classify the property and how you will intend to use it. The answer to both of these questions will impact the rules you need to follow to procure a mortgage. Here is how mortgage rules differ for seconds homes vs. investment properties.

Second Home vs. Investment Property

Whether you have a second home or an investment property is a crucial distinction and the main difference comes down to how you use the property. For example, what if you want to buy a second home to use for yourself, but also plan to rent it out when you are not using it? As a general rule, if you do not use the second home more than 14 days a year or only live there under 10% of the time it’s available for rental, then you should consider your second property as an investment property rather than a second home. 

If the home qualifies as an investment property, then the income received from it is taxable, but any expenses related to maintaining the property are tax deductible. The inverse is true for a second home – income is tax-exempt, but expenses are not tax deductible.

Contact Us for More Real Estate Investment Advice

Second Home vs. Investment Property Mortgage Requirements

Typically, lenders’ requirements are more lenient for second homes versus investment properties. Here are some rough requirements for each:

Second Home Lender Requirements

  • Credit Score: 620-680
  • Down Payment: 5%-10%
  • Debt-to-income (DTI) ratio max: 45%

Investment Property Lender Requirements

  • Credit Score: 700
  • Down Payment: 15%-25%
  • Debt-to-income (DTI) ratio max: 45%

As you can see, making the proper delineation between an investment property or a second home impacts tax considerations and financing. Investment properties have more stringent requirements because there’s a greater perceived risk of default for properties that are not owner-occupied. In other words, say a borrower runs into financial difficulties, it’s logical that he or she would stop paying on an investment property before any residence.

Perhaps the most significant difference is the down payment required — as low as 5% for a second home, while it can go up to 25% for an investment property. That is a difference of $5,000 versus $25,000 for every $100,000 financed. You will need a lot more liquid capital to purchase an investment property. Also, mortgage rates can vary wildly, but in general, rates are higher for both second homes and investment properties than for primary residences because the requirements are more stringent.

Second Home vs. Investment Property Tax Implications

As mentioned above, second homes and investment properties have different tax implications. One way they differ is tax deductions. You can deduct the interest from your mortgage for a second home, provided you are under the $750,000 total debt limit and rent it out for 14 or fewer days per year. Meanwhile, mortgage investment is completely tax deductible for investment properties. Expenses such as insurance, maintenance, and property taxes are deductible, as is depreciation.

If you exceed 14 rental days annually, the income generated is subject to income tax. While homeowners can deduct mortgage interest, with the $750,000 debt limit, you can only deduct the mortgage interest up to that amount.

However, investment properties are different, as the mortgage interest is fully deductible, and the total debt limit does not apply. Furthermore, along with the mortgage interest, the IRS allows you to deduct a myriad of different expenses, such as:

  • Maintenance
  • Advertising rental availability
  • Property taxes
  • Insurance
  • Utilities
  • Supplies, labor, and materials needed to maintain the property

You can deduct any wages paid to an electrician, carpenter, plumber, etc., for the labor to make repairs. Renovation and improvements are not deductible, however, only repairing and maintenance expenses are covered. 

Conversely, you can also use depreciation to your advantage for tax purposes. As the taxpayer, you can take a deduction annually for each investment property if it depreciates. The amount of the deduction is relative to the property’s purchase price and can be used to offset income generated by the property.

Keep in mind that this deduction is not permanent. The total amount of depreciation you take against the property for tax-related purposes decreases the house’s basis. Once you sell the investment property, you might have a more significant tax gain for that year. This is referred to as depreciation recapture and has a higher tax rate than your standard, traditional long-term capital gains tax. Moreover, you also need to keep in mind that selling your investment property will also, hopefully, generate income and, therefore, be subject to income tax.

Classifying Your Property Correctly

Since down payment requirements and interest rates are more favorable for second homes versus investment properties, you may find it enticing to classify your investment property as a second home. In short, don’t do that, regardless of how alluring you may find it. When it comes to mortgages and taxation purposes, you should always clearly and accurately disclose what your property is. Often, a lender will require signed documentation stipulating what the property’s intended use is going to be.

If you’re deceptive in your classification, it’s not just an ethics violation, it’s against the law, and you could face criminal prosecution. Underwriters are trained to spot deceptive practices regarding classifying property as a second home versus an investment property. They’ll analyze the proximity of the secondary property to the primary residence to determine misrepresentation. 

For example, if the properties are only 20 minutes apart, that might raise some red flags. Even in cases where you’re legitimately using the property as a secondary residence, you may still have to classify it as an investment property if they’re too close together.

Explore Your Investment Options With Titan Funding

For information on rental property loans or fix-and-flip loans for an investment property, reach out to the experts at Titan Funding. We’d be happy to discuss funding options with you, answer any questions you may have, or set you up for a consultation. Call us at 855-929-1134 or fill out our convenient and secure online form when you’re ready to get started.

    Ready to get started?

    Simply complete and submit this short form and a Titan team member will contact you to discuss your investment needs.