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If you thought buying your first home felt like one of the biggest financial moves of your life, you may have even more to think about if you buy a second home. In particular, you may be wondering:
- What are the fundamental differences between second homes and primary residences?
- Why can’t they both be primary residences?
- Can you turn a second home into a primary residence?
- When does my second home become an investment property?
- How do these distinctions affect your finances when you sell a home and file your tax return?
Fear not. This article will help you answer these questions so you can feel more confident in your role as the owner of a second home.
Understanding Second Homes
A second home is defined as a property that you own and live in for part of the time, but not all year long. Properties such as a vacation home, beach house, country home or pied-à-terre may be considered second homes.
The thing to remember about a second home is that it can’t be your primary residence, both for legal reasons and tax reasons. Even if you live in both houses for 6 months out of every year, the Internal Revenue Service (IRS) and your mortgage lender will still insist that only one of your homes can be considered your primary residence.
Why a Second Home Cannot Be a Primary Residence
A primary residence is usually the place where you spend the most time, and a second home is one you visit for some portion of the year. But why is this distinction so important and why do lenders and the IRS not allow second homes to be considered primary residences?
One of the main reasons is that it’s an important consideration for mortgage lenders when they’re considering your mortgage application.
Mortgage lenders know that if you get into financial trouble and can only make the payments on one of your two mortgages, you’re more likely to pay for your primary residence and let your second home go into default or foreclosure.
For that reason, your mortgage lender will want you to have a higher credit score before they’ll consider you for second home financing. Typically, your mortgage lender will also charge a higher interest rate and require a larger down payment for a second home compared to your primary residence.
The IRS is also particular about the primary residence versus second home definition because it changes how capital gains are taxed. Capital gains include any profit you make from selling a house and are subject to taxation. Capital gains from selling a primary residence may be exempt from taxation up to a certain amount while profits from selling a second home are not.
For these reasons, trying to pass a second home off as your primary residence is considered fraud.
Renting Out Your Second Home
One of the major benefits of buying a second home is that you may be able to rent it out while you aren’t living there. Over time, renting a second home may pay off the house or even become a passive income stream.
If you’re planning on renting out a second home, you should also be cognizant of the difference between a second home and an investment property. Depending on what you want to use the house for, one may be more conducive or more legally accurate than the other.
What is the difference between a second home and an investment property?
The difference between a second home and investment property and its importance to lenders and the IRS is similar to the primary-residence and second-home distinction.
You can imagine the three types as being on a scale of how much of a home a house is, with primary residence being the homiest, an investment property not being a home at all and a second home as being the awkward Jan Brady between the two.
The confusing part is that the IRS and some lenders may have different definitions of what they consider an investment property.
The IRS defines a second home as a property you visit at least 14 days out of the year or 10% of the days it’s rented. For example, if you buy a house and strictly rent it out, that would not be a second home. On the other hand, a home you rent out most of the year but live in all summer could be.
Lenders’ ideas of a second home and investment property can vary, and they may consider a house an investment property even if it isn’t rented out yearlong.
To ensure your second home stays one to the IRS, and that you don’t run into issues with your lender, plan times to stay there each year and don’t break any of the requirements the lender set.
Be transparent with your lender during the mortgage process about how you plan to use the house. They can let you know if there would be any issues or if you would need to consider an investment property mortgage.
What Else You Should Know About Second Homes
There are more nuances to owning a second home than a primary residence. Here are some common questions second home buyers ask to help you get started.
Can a second home become a primary residence?
Yes, a second home can become a primary residence. For eligibility, you have to meet the IRS qualifications for a primary residence, which is that the home was used as your primary residence for 24 months out of the previous 5 years.
There are a few reasons you might want to do this.
- Relocate: Your second home might offer a warmer climate or better amenities than your current primary residence. By relocating you can spend more time in your second home and reap all the benefits that come with it. This option tends to be popular for retirees or empty nesters who may not be locked down to a specific location for work or family like they once were.
- Downsize: Let’s say you raised your family in a beautiful 2-story suburban home. But now the kids have moved out. The home you own may be larger than you need, or if you have mobility or accessibility issues, you may want a home without stairs.
Making your second home your primary home may allow you to downsize to a more comfortable situation. Then you can turn your original home into a rental property or sell it to finance your new lifestyle.
- Avoid capital gains: Another reason to make your second home a primary residence is if you plan to sell the second home and want to avoid paying capital gains taxes. There are costs associated with switching primary residences, so make sure you’ve done the math to make sure the switch is worth the money you’ll save on capital gains.
If you move to the second home and meet the qualifications, you shouldn’t run into any trouble with the IRS or lenders. However, you should consult a lawyer before making any decisions to ensure you don’t commit fraud.
What happens if I sell my second home?
Selling your second home is similar to selling a primary residence. The major difference is how it’s taxed. You won’t have the same exemption options for capital gains taxes that you would with a primary residence. Capital gains taxes can claim as much as 20% of your profits and are calculated based on your income and how much profit you made.
If you’re selling an investment property, you have the option to utilize the 1031 exchange option. This may let you defer capital gains taxes if you buy another investment property of equal or greater value within a certain time frame.
How does a second home affect my taxes?
Even if you aren’t planning to sell your second home, there are other ways your taxes will be affected. You may have to pay more in property taxes or pay taxes on the rental income you make from investment properties.
You may also be able to deduct the interest from your second home mortgage on your tax return. However, under the 2017 Tax Cuts and Jobs Act, homeowners filing jointly are now only allowed to deduct the interest on up to $750,000 in mortgage debt ($375,000 or less if married filing separately) on both their first and second homes, a 25% reduction from the $1 million joint filers could deduct before.
Also, while you were previously allowed to deduct all of the property taxes you paid from your federal income tax, you can now only deduct up to $10,000 in property taxes.
Before making any decisions, talking to financial advisors, looking at lending options and researching second homes are all ways to make sure it’s the right decision for you.
Second Home to None (Except Your Primary Residence)
A second home may be a good investment for you. If it’s something you’re considering, start working on your credit and financial health now. The underwriting process will be a lot smoother on a second home or investment property if you stay vigilant with your finances.
Home is worth it.
Take the first step toward owning a home. You’ll be glad you did.
The Short Version
- The thing to remember about a second home is that it can’t be your primary residence, both for legal and tax reasons
- The IRS defines a second home as a property you visit at least 14 days out of the year or 10% of the days it’s rented
- Trying to pass a second home off as your primary residence is considered fraud
Internal Revenue Service. “Topic No. 415 Renting Residential and Vacation Property.” Retrieved May 2022 from https://www.irs.gov/taxtopics/tc415
Internal Revenue Service. “Publication 523 (2020), Selling Your Home.” Retrieved May 2022 from https://www.irs.gov/publications/p523
Internal Revenue Service. “Topic No. 409 Capital Gains and Losses.” Retrieved May 2022 from https://www.irs.gov/taxtopics/tc409
Internal Revenue Service. “Like-Kind Exchanges – Real Estate Tax Tips.” Retrieved May 2022 from https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips
Internal Revenue Service. “2021 Publication 936.” Retrieved May 2022 from https://www.irs.gov/pub/irs-pdf/p936.pdf
Internal Revenue Service. “Topic No. 503 Deductible Taxes.” Retrieved May 2022 from https://www.irs.gov/taxtopics/tc503