Your Next Home Purchase Can Be For Fun Or Money...
Because Santa Barbara and Montecito are desirable and beautiful places to spend time, many buy vacation homes here to get away from the hustle and bustle of city life. Also, because of this, many will buy an investment property here and list it on Airbnb or VRBO. Whatever you decide to do, you should know the differences in these two different types of real estate purchases and how it can impact you down the road.
Why Does It Matter If You Buy an Investment Property or a Second Home?
As Benjamin Locke points out in this recent article on Supermoney, the IRS classifies properties differently for tax purposes. As an investment, you will need to treat the home more like a small business on your taxes, claiming any improvements and other expenses as loss and any revenue you receive in rents as income.
How they are classified in this manner is covered by Benjamin, where he shows that you would need to not only live in the property for 14 days out of the year, but additionally for 10% of the time you rent it out. So if you rent your home out for 140 days, then the 14 day rule has you covered. However, if you rent it out for 200 days, then you must be there at least 20 days of the year. Conversely if you only rent it out for one week, then you would need to stay in the home for 14 days.
Investment properties also need to meet the classification of being purchased with the goal of making a profit and taking advantage of some tax benefits assigned to investment properties. Be aware that there are also major tax implications to both of these types of purchases.
Should I Take Out a Mortgage To Buy A Second Home or Investment Property?
If you decide to mortgage your second home, then you can expect to pay rates similar to regular residential homes. If you were planning to take out a mortgage on an investment property, you can expect to pay a higher rate, mainly because banks see a secondary home as a risk. If you think about it, if someone is in financial duress and has two mortgages to pay, the mortgage on the home where they aren't living may get put aside for the payment on the primary residence.
What If I Mortgage An Investment Property or Second Home?
On your primary residence, if you take out a mortgage to purchase it, then the interest can be deducted. This is one of the many benefits of homeownership. However, if you do buy another property, then the classification will matter and impact what happens come tax time.
Mortgage Interest Deductions For Investment Properties:
You can deduct the mortgage interest as a business expense, which effectively lowers the taxable income from the property. You conversely can deduct the mortgage interest directly on your taxes, but bear in mind there are limitations to the total amount you can deduct.
Deducting The Mortgage Interest For Second Homes
Unlike an investment property, mortgage interest can not be deducted as a business expense unless you have a home office in your second home. However, you can only deduct the percentage of the interest that correlates to the size of the home office. So if your home office makes up 12% of the home's total square footage, then you can deduct 12% of the interest as a business expense. Otherwise, you can deduct the interest like you would your primary home, however this is subject the limitations mentioned above.
How Much Money Do I Need to Put Down On a Second Home or Investment Property?
Down payments are different when you purchase investment homes or vacation properties. For a second home, you can expect to need a 5-10% down payment, which is much lower than a primary residence. If the home is being purchased as an investment, you will most likely need to bring 20-30% to the table for a down payment to qualify for the loan. Again, this gets back to the point that banks see this as more of a risk than a residence.