Real Estate Guide: Secondary Homes vs. Investment Properties

For those that already own a home, buying another property can be a great place to put extra cash that might be sitting unused in your bank account. Even if you’re not planning on renting your new property, a second home could be a good investment as well, as real estate tends to increase in value over an extended period of time. After deciding to buy real estate, most people have trouble figuring out the purpose of the new property: will it be used as a secondary residence or will it be used as an investment property.

Buying a secondary residence or an investment property can be a major financial decision, but like most things, it really depends on how you want to use the property — do you anticipate using the property as a vacation home during the summers or holidays or is it likely that you won’t use it for more than a few weeks out of the year? This could impact how you want to designate the property.

It’s also important to understand that both a secondary residence and an investment property can provide financial benefits when it comes to financing options and tax benefits, so it’s crucial to know the different advantages between these types of properties when determining which might be more suitable for your specific financial situation.

How are secondary residences and investments properties defined?

As we’ll later discuss, whether a buyer defines the property as a residence or an investment property can impact the tax benefits and financing options available to them, as each type of property has its own advantages in each of these areas. However, once they designate a property for residence or investment use, there are certain requirements and regulations that need to be upheld in order to steer clear of what could be considered tax or mortgage fraud.

Vacation homes, pied-a-terres, residences used-for-work, and short-term rentals could all be considered secondary residences. Though it is possible to generate income off of a secondary residence, there are a few guidelines that are required by both the IRS and lenders. The IRS defines a secondary home as a single-unit property that is lived in by its owner for 14 days a year or 10% of the days that the home was rented — whichever is higher. For example, if the owner rented out the property for 180 days in a year, they must be able to provide some type of proof that they lived in the property for at least 18 days in the same year.

Additionally, lenders will only consider a property a secondary residence if it doesn’t have a long-term lease with a tenant, isn’t being used as a timeshare, and is under the control of the owner and not a rental agency or management company. Some lenders may require that a property be more than 50 miles from your primary residence to be considered a second home.

On the other hand, investment properties can be more than one unit, don’t have any short-term or long-term rental requirements, and can be rented out to third-parties for 365 days a year. However, if the owner lives in the property for 14 days or more than 10% of the days that the property is rented, the property will be considered a personal residence.

Are there implications for claiming an investment property as a secondary residence?

Most lenders will require borrowers to sign a document stating how they intend to use the property, so it’s best to have a clear idea of how you want to use the property before closing on a loan.

You might think you have found a loophole by listing an investment property as a second home or vice versa to take advantage of certain mortgage or tax rates, but doing so could have serious consequences. Listing a property as a secondary residence when in fact you intend to use the property as an investment and not fulfill all of the requirements needed for a personal residence can be considered mortgage fraud. Mortgage fraud is a federal crime and can carry severe fines.

On the flipside, claiming a personal residence as an investment property to take advantage of tax benefits can be considered tax fraud. Tax fraud is also considered a federal crime and can also carry severe fines.

However, it’s not uncommon for an individual to change his mind and convert a secondary residence into an investment property, or vice versa. In this scenario, it is best to check with your lender and read all your mortgage paperwork to confirm that you wouldn’t be violating any terms of the mortgage agreement.

Mortgage qualifications, rates, and terms for an investment property and a secondary residence

One of the main benefits of purchasing a second home instead of an investment property is that a second home will generally provide an easier path to getting a mortgage — and not only that, but a mortgage for a second home is more likely to have better rates and terms than an investment property. This is due to the fact that lenders view investment properties as carrying with them a higher risk of default, as they believe that borrowers are more likely to walk away from paying the mortgage on an investment property than on a primary, or even secondary, residence.

In order to be eligible for a mortgage on an investment property, most lenders require borrowers to have a credit score of at least 680 — though many lenders might require a higher score — a debt-to-income ratio of roughly 45%, and to have the wherewithal to be able to put down at least 25-30% of the property’s value as a down payment.

In regards to a secondary residence, most lenders require borrowers to have a minimum credit score in the 620-650 range, a debt-to-income ratio of 45%, and the ability to put down at least 5-10% of the property’s value as a down payment (for context, a primary residence might only require a down payment of somewhere between 3-5%). Also, mortgages for second homes will generally have lower interest rates than mortgages for investment properties.

Tax advantages for secondary residences and investment properties

Secondary residences and investment properties have different tax treatment. In general, the tax benefits of a secondary residence are less favorable than those of an investment property.

One key difference is that the mortgage interest on a secondary residence is typically not tax-deductible, while the mortgage interest on an investment property is generally tax-deductible. This can make a significant difference in the amount of taxes you owe each year, particularly if you have a large mortgage.

Another difference is that any rental income you earn from an investment property is taxable, while rental income from a secondary residence is not. However, you may be able to claim certain deductions for expenses related to renting out a secondary residence, such as repairs and maintenance.

Things to consider when deciding between a second residence or an investment property

There are many things to take into account when deciding between how you want to use this new property, such as:

_Do you want the flexibility of using the property as a vacation home whenever you want or do you only anticipate using it during specific times of the year?

If you are going to personally use the house, for how much time do you anticipate using it? Would you be willing to rent it out when you’re not around?

For renting purposes, do you prefer having the stability of long-term tenants or do you like the idea of lots of short-term tenants?

Will the tax benefits of an investment property outweigh the financial impact of being able to get better rates and terms on a mortgage?_

For those that are looking to buy a property, or want to make improvements on a current property to raise its value, a cash-out refi might make sense. However, there are many more aspects to keep in mind when examining if a cash-out refi is the right financial move, and a lot of these are situationally dependent.

Wondering what's the best financial decision for you? Speak with one of our loan consultants to determine what's the best move for you. Click here to book.

The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product.