So, you’ve been thinking about buying another home where you’ll either have a place to go for vacations, or a place that’ll generate income and put more money in your pocket. Either way, the opportunity to own more than one property is an enviable position to be in, but how you classify that property makes a difference in how much you’ll pay to finance and own it.
Second home vs. investment property
Are you buying a second home, or are you making an investment?
This might be confusing, especially if you’re thinking about using it regularly for vacation but also making it available on a platform such as Airbnb or VRBO.
Earning some money from your property doesn’t automatically make it an investment. Accurately defining the piece of property depends on how much time you spend in it.
Generally, a second home is like a vacation home — one you purchase for enjoyment purposes and live in during part of the year. In contrast, an investment property is one you plan to rent out with the goal of generating income.
Lender requirements for second homes vs. investment properties
Second home lender requirements
- Minimum credit score: 620-680 or higher
- Minimum down payment: 5%-10%
- Maximum debt-to-income (DTI) ratio: 45%
Investment property lender requirements
- Minimum credit score: 700 or higher
- Minimum down payment: 15%-25% or more
- Maximum DTI ratio: 45%
Making the distinction between a second home and investment property is important not only for tax purposes, but also for when you seek financing for the home.
If a borrower has trouble making mortgage payments, they’re more likely to keep up with the payments on their primary residence, than payments for a second home and that’s a riskier prospect for lenders.
For instance, Navy Federal Credit Union requires a 25 percent down payment for an investment property, but if you’re looking at a second home, the down payment could be as low as 5 percent.
That’s a huge difference!
Mortgage rates for second home vs. investment properties
While mortgage rates are still low historically-speaking, they’re on the rise, and in general tend to be higher for second homes and investment properties, since they are riskier prospects for lenders.
Tax implications for second home vs. investment properties
Second home tax implications
- The mortgage interest on a second home is tax-deductible so long as it falls within the $750,000 total debt limit and you don’t rent out the property for more than 14 days per year.
Investment property tax implications
- The mortgage interest on an investment property is fully tax-deductible. You can also deduct many expenses related to the property, including property taxes, maintenance and insurance, as well as for depreciation.
- If you rent out the home for more than 14 days per year, the rental income is taxable.
For an investment property, however, the rules are different.
In addition to deducting mortgage interest, investment property owners enjoy the ability to deduct a wide range of expenses. The IRS says the following costs are deductible:
- Property taxes
- Advertising the property to attract renters
- Materials and supplies used for the upkeep of the property
If you hire someone to do the work, too, such as a carpenter or an electrician, you can deduct their wages. However, you’re not allowed to deduct the cost of a renovation to improve the property.
On the opposite end of improvement, investment property owners can use depreciation to their advantage, as well.
In addition, whenever the selling year arrives, an investment property owner can be subject to income tax if the sale results in a profit.
According to smartasset.com, second homes “can also generate rental income and tax deductions for expenses, as long as the owner lives there for at least 14 days a year or 10% of the total days rented.”
Personally, we love the idea of owning a vacation home where we can spend time each year unwinding & recharging, while using it as a short-term rental (commonly referred to as STR) to cover the mortgage & expenses for the year! If this is something you are interested in, you will want to do your homework and be sure that STRs are allowed in the area you are looking.