A second home and an investment property will be treated differently from both a legal standpoint and a lending standpoint. The property’s status depends on how the owner uses the property and the number of days per year they use it. However, a second home can potentially turn into a more profitable investment property with a short-term rental strategy.
If you have some extra money in the bank and an interest in real estate, then chances are, you are combing Zillow for property investment opportunities. Either you are looking at a second home you can enjoy or an investment property you can rent out and earn income. It might even be possible to do both. Here is what you should know.
What is a second home vs. an investment property?
A second home is a home where you live for part of the year or visit regularly. Investment property, on the other hand, is a property you have purchased to rent to tenants. They differ from both a legal and tax standpoint, as well as a lending standpoint.
What is a second home?
A second home is a home in addition to your primary residence where you might live for part of the year. Usually, you have a second home for the following reasons:
- A vacation home you use for part of the year
- A place you use for work, a “pied-a-terre.”
- A place you bought, and you let family members live there without paying rent
The reason this matters is that a second home will often be treated differently than other investment property. The IRS states that a property is defined as a second home if the following criteria are met:
- You visit the home for at least 14 days
- You stay in the home at least 10% of the time it’s rented out
- It can only be ONE unit
Regardless, this means that if you rent the property out for 200 days a year, you need to stay there for at least 20 days. Pay attention to these numbers, as short-term rentals also qualify.
What is an investment property?
An investment property is a property you purchase for the purpose of deriving rental income or selling the property for capital gains. The main goal of this property is to make money and generate income! Therefore, from a legal/tax standpoint as well as a lending standpoint, it is treated differently. The IRS states that a property is defined as an investment property if the following criteria are met.
- The property’s main goal is to produce a profit
- Property is used to take advantage of certain tax benefits
Now that we have the definitions, why does this matter? The main reasons are lending and tax.
Second homes vs. investment properties: taxes
Understanding the tax implications is crucial when distinguishing between second homes and investment properties. Let’s delve into two major areas that differentiate them: mortgage interest and expenses.
- Deductibility: Mortgage interest on a second home is typically deductible, similar to your primary residence.
- Limitations: It’s essential to recognize that mortgage interest deductions may have limitations based on various factors, including the amount of the loan.
- Mortgage Interest Deductibility Confusion: Mortgage interest is also deductible on investment property.
- Business Expense: Mortgage interest can be written off as a business expense, reducing the overall taxable rental income. This deduction is in contrast to a second home, where the mortgage interest is not deductible for business purposes.
- Limited Deductions: With a second home, you generally cannot write off expenses related to maintenance, utilities, or property taxes.
- Special Circumstances: However, if you rent out the second home for part of the year, you may qualify for certain deductions, but strict rules apply.
- Broad Range of Deductions: As an investment property is considered a “business,” you can write off a variety of expenses. These include:
- Utility Bills: Water, electricity, gas, and other utility bills can be deducted.
- Maintenance: Costs for repairs, maintenance, and improvements can be written off.
- Property Taxes: You may deduct property taxes as a business expense.
- Depreciation: The gradual wear and tear of the property can be deducted over time.
- Mortgage Interest: As mentioned earlier, this can be deducted as well.
Second homes vs. investment property: lending
Just as legally and tax-wise, second properties are considered different from investment properties, the same stands for how lenders are willing to lend. Here is how they differ.
Mortgage interest rates
A second home is seen as just behind a primary residence in terms of risk. People don’t want to lose their primary residence as well as their second homes. Thus, mortgage interest rates will differ.
With an investment property, the interest rates will be higher than for a secondary home. Again, this is because banks see a second home as a higher risk.
With a second home, the down payment will be less than it would be for an investment property but probably not as low as it would be for a primary residence. You will be looking at a minimum down payment of around 5%-10%.
With an investment property, the down payment will be a minimum of 15% but expect to pay more. Many investment property loans will require a 20%-30% down payment, and perhaps more, depending on the terms of the loan as well as the property.
A lender will often be willing to lend for a second home with a credit score that is not pristine; typically, a credit score of 620+ is necessary.
An investment property will require a higher credit score, starting at 700. But in most cases, you will want a 720+ score to obtain a decent loan for an investment property.
You can only have two “residential mortgages” — a primary residence and a second home. Other than those two, the rest will have to be investment property mortgages.
Technically, an investor can have an unlimited amount of investment property mortgages. This, of course, relies on the investor maintaining a good credit score and debt-to-income ratio (DTI).
How to choose a second home vs. investment property
Although the tax and expense write-offs for investment properties are an advantage, the low down payment and interest rates make one thing clear. If you are building a portfolio of properties, then you will want to take advantage of having at least one second home property mortgage.
Deriving income from a second home with short-term lets
Remember, an investor can rent out a second home as long as they stay in the home up to 10% of the number of days it’s rented out. In previous decades, this didn’t mean as much unless you had a holiday property in the mountains, for example, in which you were able to use a short-term holiday property.
Airbnb, VRBO, etc.
That all changed with the rise of Airbnb, which transformed the short-term rental market. Now, regardless of the location of your property, you can rent it out on a short-term basis as long as it complies with the short-term letting laws of the county and municipality in which it’s based. In fact, many real estate professionals have seen an uptick in property sales for clients who are looking for an Airbnb rental rather than a place to live.
Maureen McDermut, a real estate professional, has seen this happen in the Santa Barbara market. “I have seen an increase in home purchases for the purpose of generating income via Airbnb,” she says. “The Santa Barbara area is very idyllic, so a lot of people come here for vacations. One of the interesting things about this is the number of out-of-state buyers investing in this type of property, where some are using them as a part-time vacation home as well as a VRBO.”
Short-term rental income is just one way to earn some extra money. Check out these other side jobs.
What about the appraisal? Any difference?
Many people ask about the appraisal of the home and if there is any difference between a second home and an investment property. We spoke to Candice Krasovec, a certified appraiser in Washington and Texas. “The value won’t necessarily be different,” she says. “They both have the potential to earn income as a rental or not. If they are side-by-side, the only difference in the appraisal process would be that they are non-owner occupied, in which case the loan may be higher. They are both not the primary residence, however, it may be treated differently as an income-producing property, in which case the appraiser would do a further analysis of the potential earnings. So that would be the only difference in the appraisal process.”
How is a second home distinct from an investment property?
A second home is a home where you plan to live for part of the year whereas an investment property is something you plan to rent out for profit. Furthermore, you can only have one additional “residential mortgage” with a second home; all additional mortgages must be investment related.
How does financing for a second home differ from financing for an investment property?
From a financing perspective, investment properties will require higher down payments and have higher interest rates. They will also require a greater credit score than second-home properties.
What are the considerations to keep in mind when deciding between a second home and an investment property?
Tax implications, down payment costs, your loan-to-value ratio, interest rates, and general loan terms are all aspects to consider when buying a home. However, you can rent out a second home as long as it’s in line with any legal requirements. Therefore, as the loan terms are generally better, investors should have at least one property with a primary residence mortgage and one with a second home loan. All additional properties can have an investment property loan. However, be careful to follow the loan terms and rules, as behavior that deviates from the norm could be considered mortgage fraud.
- A second home and an investment property are treated differently from both a legal standpoint as well as a lending standpoint.
- A second home can be used as a rental property, but the owner must live in the property for 14 days a year or 10% of the number of days it’s rented out. An investment property loan is treated more like a business loan, and there are no such requirements.
- With a second home, there generally are not as many tax write-offs, but the lending terms and rates are better than for an investment property.
- With short-term rentals, a second home doesn’t need to be in a resort or vacation area. It can be anywhere if the property complies with local regulations.
View Article Sources
- Residential Rental Property – IRS.gov
- Renting Residential and Vacation Property – IRS.gov
- Tips on Rental Real Estate – IRS.gov
- How to Finance Investment Property – SuperMoney
- Investing In Real Estate Pros and Cons: 2023 Update – SuperMoney
- Rental Property Tax Deductions: Saving More Money – SuperMoney
- How to Finance a Vacation Home (Updated 2023) – SuperMoney
- How to Invest in Airbnb Rental Properties – SuperMoney
- Primary Residence Mortgage: Definition & Benefits – SuperMoney