If you’re considering purchasing another property outside of your primary residence, you may be wondering what to call it.
If you plan to travel to the new property with your family for fun, you might consider it to be a vacation home. But if you also occasionally rent it out, at what point does it become an investment property?
You can use any of the terms “second home,” “vacation home,” and “investment property” informally to refer to your new property, but you’ll need to know what technical terms apply for tax and legal purposes. Banks and the U.S. government have more specific criteria that they use to distinguish between properties intended primarily to generate income and those considered to be primarily personal assets.
Below, we’ll go over more of the differences, and explain what you need to know before you decide how to classify your new property.
How Banks and the IRS Define Vacation Homes
There are essentially two institutions whose definition of your property as either an investment property or a residence (referred to colloquially as a “second home” or “vacation home”) matters:
- the bank that will be issuing your mortgage
- the IRS, whose classification will determine what income, payments, and losses related to the property are taxable or deductible
First of all, if you never plan to rent your new property out or charge anyone to use it, the classification is simple: The property will automatically be considered a residence.
But if you plan to rent the property out for any amount of time, you’ll need to do a bit more research to understand how it will be classified.
The IRS uses a pretty straightforward definition for whether or not a dwelling is considered a residence or an investment property for tax purposes. A dwelling is considered a residence if you use it for personal purposes during the tax year for more than the greater of:
- 14 days, or
- 10% of the total days you rent it to others at a fair rental price.
So, staying in the home for 14 days of the tax year is all you need to be considered a residential home — unless you rent it out for more than 140 days of the year. In that case, you’d need to increase the number of days you stay in the home in order to stick to the 10% ratio for your property to be classified as a residence.
In another example, if you stay in the home just three days during a tax year but only rent it out for 30, your property would still be classified as a residence for tax purposes — because you stayed in it 10% of the time it was rented.
The mention of a “fair rental price” clarifies that letting friends and family use the property throughout the year for below-market rates doesn’t count as an actual rental. Each day that friends, family, or anyone else stays in the unit for below-market rates counts toward the personal-use days of the property.
Banks have their own criteria about what constitutes a rental home vs. a vacation property, and those criteria can vary from one institution to the next.
Banks tend to be much stricter than the federal government in classifying a property as a second residence, because investment properties are riskier investments. The reasoning: Property owners are more likely to abandon (or stop being able to afford) if a business isn’t working out, but for people investing in a second home, any rental income is just a nice bonus.
Banks don’t want people claiming that a home down the street is a vacation home in order to get a better mortgage rate, so they have additional lending requirements.
As this Nolo post explains, some banks require that a second home be located in a desirable area for rentals, such as near the beach or mountains or another attraction. Others require a second home to be a minimum distance away from an owner’s primary residence to meet the criteria for a residential mortgage. And still others specify that in order for a home to be considered a second residence, it should not be rented at all.
How Should You Classify Your Property
We’re not tax experts or lending experts, and you should definitely have conversations with qualified professionals before making any big financial decisions.
However, below are some main points that can give you a general idea of which classification might make the most sense for your property.
Financial Advantages of a Second Home
- As we mentioned earlier, mortgage rates tend to be lower for second homes than investment properties.
- Owners of a second home may be able to deduct mortgage interest on their income taxes.
Financial Advantages of an Investment Property
- Owners of an investment property may be able to write off annual losses and depreciation on their taxes.
- Owners of a second home may be able to write off expenses such as repairs, renovations, and marketing costs.
The classification that makes the most sense for your property will depend on how you are going to use it.
As this MoneyCrashers article points out, tax rules are complex and can vary based on other factors, including an owner’s other income:
“As a consequence, sophisticated real estate owners frequently use a combination of legal entities – trusts, C corporations, Sub-Chapter S elections, and limited liability companies (LLCs) – to buy, manage, and sell their real estate assets. The owners typically engage in subsequent complex transactions between the entities to minimize legal and financial liability or maximize their personal tax benefits.”
As we mentioned in our post What Makes a Second Home a Good Investment, understanding how much you can really expect to make out of a property long-term requires a lot of research into how much the property will cost to maintain and market, in addition to the financial aspects or the mortgages and taxes.
But the measure of what a property is actually worth to you is more complex.
Much of the value you’ll get from purchasing a second home is about the enjoyment you get out of the property each year. For most second home owners, the property will come to represent a place of respite and relaxation. It will be a destination for vacations, holidays, and special trips, and will be the source of many happy memories.Before you get too deep into real estate investment finance analysis, consider whether your personal enjoyment of the property is worth the time and energy. Click To Tweet
And if you’re looking for an amazing property that would be well suited to a vacation home or an investment property, you should definitely check out the homes of Upper East River in Savannah.
The homes of Upper East River are luxury, single-family homes in a new riverfront development called Eastern Wharf. Homeowners can choose from among a variety of home plans, from luxury lofts to historic rowhouses, all of which were expertly designed to blend with Savannah’s historic architecture and character.