When you decide to buy more property, your intentions will affect almost everything about your purchase, from your interest rate to taxes. Learn more about the differences between second homes and investment properties.
Compared to second homes, investment properties typically have stricter lender requirements, including minimum credit scores, interest rates, and down payments. Investment properties are also eligible for more tax deductions, but you will have to pay taxes on rental income.
Take a closer look at the distinctions between second homes and investment properties, including what they are and the differences in mortgages and taxes.
Second Homes vs. Investment Properties: Everything You Need to Know
If you already live in your own home and want to buy another property, lenders will ask whether you intend it to be a second home or an investment property. The taxes you pay for the said property will be affected by how you categorize it. As such, it is important to understand the difference between the two.
Seconds Homes vs. Investment Properties: The Difference
Before we can get into differences in mortgage rates, requirements, and taxes, you need to understand the difference between the two types of properties. Their difference comes down to how you will use the property.
In some cases, your goal is obvious. A second home is an accessible place for you to live in at least some of the time. You may have several of these one-unit "second homes." Meanwhile, an investment property is a place you don't plan to live in and will use to generate income. You can rent it out short-term, like an Airbnb, or long-term, such as annual contracts. Investment properties can have multiple units, such as condominiums or apartment buildings.
Note there are some gray areas. You might be wondering how to classify property that you live in only during some parts of the year and rent out the rest of the time. The 14-day rule is the key here. It essentially means that if you live in the property for 14 days or fewer yearly, it is considered rental property. You can also compare the duration of living there and the duration it is rented out. If you live there less than 10 percent of the total number of days it is rented, it is an investment property. So, if it is rented out 200 days in a year, 20 days would be 10 percent. If you lived there only 19 days, it is considered an investment property.
These distinctions affect your taxes significantly. Rental income on investment properties is taxable, but expenses on the property can be deducted. With a second home, you don't have to pay taxes on rental income, but you also can't deduct expenses.
Mortgage Rates for Second Homes vs. Investment Properties
As mentioned, your lender will ask you whether the home you plan to buy is a second home or investment property. They need to make this distinction because they will have different requirements for each. The exact requirements will depend on the lender, but there are some general ranges across all lenders.
Minimum Credit Scores
If you are buying a second home, expect your lender to require a credit score of 620 to 680 or higher. By contrast, lenders typically require a score of at least 700 for investment properties.
Minimum Down Payments
You can make a down payment as low as five to 10 percent for a second home. For investment homes, on the other hand, expect to pay 15 to 25 percent.
There is one notable exception. If you want to buy a multi-family home and plan to live in one of the units for at least a year, you may qualify for a Federal Housing Administration (FHA) loan. This would come with a down payment minimum of just 3.5 percent. You could even use the income from rental units as a means to help you qualify. If you qualify for a VA loan, there is a similar option with a zero percent down payment. That option can include investment properties with up to seven units.
Maximum DTI Ratio
Whether you want to buy an investment property or a second home, expect your lender to require a maximum debt-to-income ratio of 45 percent.
You can also consider the fact that investment properties will have higher interest rates compared to second homes.
Why There Are Differences
The major reason that investment properties have stricter requirements is that they come with risks. Lenders assume that there is a greater risk that you will miss payments if you won't be occupying the property. Their assumption stems from the thought that you would ensure payment for the property you live in, and investment properties would become an afterthought if you ever struggle financially.
This is why you will notice that the requirements for buying a primary home are even lower than those for secondary homes. Depending on the loan type, you can get a zero percent down payment (VA loans) or 3.5 percent down payment (FHA loans) for your primary residence. Lenders assume you will prioritize paying that property's mortgage because you need to keep a roof over your head. You can expect a difference in interest rates between primary and secondary homes of 0.50 to 0.875 percentage points or more.
Some Lenders Let You Account for Rental Income
One caveat here is that some lenders may let you use as much as 75 percent of the predicted rental income to offset your mortgage payment. This would only apply to investment properties. If your lender offers this, expect to pay more in fees, as you will need a specialized appraisal that also looks at comparable rental rates. Your lender may also require proof that you have property management experience.
IRS – Second Homes vs. Investment Properties
In addition to differences in financing, your taxes will also be based on whether a property is for investment or a second home.
For second homes, the interest you pay on your mortgage is tax-deductible as long as you don't rent out the property for more than 14 days every year. It is also worth noting that you can only deduct a maximum of $750,000 total from mortgage interest. This includes both your second home and your primary residence.
By contrast, there is no limit to your deduction of mortgage interest on investment properties. On top of that, you can deduct other relevant expenses, including maintenance, insurance, property taxes, and depreciation. But remember that if you rent out your investment property for more than 14 days every year, you will have to pay taxes on the rental income.
Tax Benefits of Second Homes vs. Investment Properties
We touched on the tax benefits for second homes via deductions versus investment properties. Still, it is worth delving deeper into two crucial distinctions.
The first distinction is that you have a mortgage interest deduction limit of $750,000 for second homes and none for investment properties.
What You Can Deduct
The other difference is what you can deduct. With either second homes or investment properties, you can deduct interest on your mortgage. However, investment property owners can also deduct the following:
- Property taxes
- Supplies and materials used to maintain the property
- Wages of individuals hired to maintain the property (except renovations for improvements made)
- Advertisements of the property to tenants
Keep in mind that the deduction for depreciation can be somewhat complicated as it will reduce over time. It is also possible that you will have depreciation recapture when you sell the property. That would happen if you had a larger tax gain on the year of the sale. That's important to consider as depreciation recapture has a higher tax rate than other long-term capital gains.
Remember that these increased deductions for investment properties aren't necessarily an overall benefit over second homes. You will also be required to pay taxes on the rental income from the property. You may also have to pay income tax if you make a profit when you sell the property.
Can I Pretend My Investment Property Is a Second Home?
Given that second homes have lower interest rates, down payment requirements, and credit score requirements than investment properties, it may be tempting to declare to your lender that the additional property you are purchasing is a second home. However, you should not mislead a lender because it is tantamount to mortgage fraud. That could lead to criminal prosecution.
There are also more minor consequences than criminal charges. Most lenders require you to sign an occupancy affidavit. This document lets the lender foreclose the loan if you claimed an investment property as a second home. In other words, being honest with your lender about what you plan to do with the property will save you from unwanted consequences.
Can I Change a Second Home Into an Investment Property?
As long as your mortgage allows it, you can turn a second home into an investment property at some point. Your mortgage may have a minimum duration for considering it a second home before you can change its status. You will also have to make adjustments on your next tax return.
Second homes are properties that you occupy for at least 14 days of the year, while investment properties are used to generate income, such as short-term or long-term rent. Investment properties have stricter mortgage requirements, including higher minimum credit scores, interest rates, and down payments. You will have to pay taxes on rental income from investment properties, but these properties are also eligible for more deductions than second homes.
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.