Second Home vs Investment Property – What is Your Best Option?

Are you considering buying an extra property but are not sure how to classify it? There are stark differences between a second home vs investment property, including how you can use them, the available loans, and how they are taxed.

You might be planning to classify your next purchase as an investment property, but it might qualify as a second home. You would be missing out on some profound benefits if you failed to label it as such. Even with a traditional rental property, there are many tax benefits that you should be aware of.

In this article, we’ve laid out the differences between a second home and an investment property so you can choose which one fits your situation. Also, by knowing these differences and the advantages of each approach, you can tailor your plans to meet your goals.

What is a Second Home?

A second home is a property apart from your primary residence. Also, you live in for a portion of each year. There are a few criteria that it must meet for you to consider a house to be your second home:

• Must be located at least 50 miles from your primary residence
• You must use the property at least 14 days a year or 10% of the days you rent out, whichever is greater.
• Nearly all second homes are single-unit properties such as single-family homes and condos.

Some of the most common reasons people consider buying a second home are to have a place to stay at their favorite vacation spot or an area they frequently travel to for work. Instead of renting a place every time they travel, they can live in their own home that they are more familiar with.

It is legal to rent out your second home for a portion of the year as long as the personal use requirements are met. Most people that own second homes use Airbnb and VRBO to cover their mortgage payments and supplement their income for a portion of the year.

What is an Investment Property?

An investment property is a property you purchase with no intention of personally using. Instead, it is solely for serving as an investment and generating revenue. The most common types of investment properties are rentals and flip houses. However, in a lender’s eyes, any home you own and do not personally use is considered an investment property. 

Unlike second homes, investment properties often consist of multiple units, such as duplexes and four-plexes. However, if you want to invest in a property with more than four units, it would be considered commercial, and the loan requirement would be different.

Benefits of Having a Second Home

Aside from having a place to stay when you travel, owning a second home has considerable benefits. When comparing a second home to an investment property, the primary advantages involve the mortgage and property taxes. Let’s take a look at what these are.

Can You Get a Better Loan on a Second Home?

The loan you can get for a second home will typically be more favorable than what is available for investment properties. Generally, a primary residence will give you the best options for interest rate and down payment, a second home mortgage is a close second, and investment property will be the least favorable.

There are low down payment options such as FHA (Federal Housing Administration) or VA loans when borrowing for a primary home. However, a loan for a second home will nearly always be conventional. The requirement for this type of loan will typically be 10%. However, you will have to pay PMI until your equity in the house reaches 20%.

The interest rates for a second home are comparable to those for a primary residence for most borrowers. For comparison, the interest rate on an investment property will usually have a higher interest rate because a lender may consider them more of a default risk. If you can, this interest rate difference is the only reason you should consider classifying your next purchase as a second home.

The one drawback to getting a second home loan is that you will have to qualify for it on your income alone. With an investment property, most lenders will give you credit for the rent you will receive on your debt-to-income ratio. However, you don’t get this credit on a second home.

How Do Taxes Work on a Second Home?

The primary tax difference between a second home and an investment property is that you can deduct the mortgage interest from your second home on your taxes. While you can’t do this on investment property, you can classify your investment property mortgage interest as a business expense and use it to offset your taxable rental income.

On an investment property, you can use most expenses to offset the rental income to reduce the amount of taxes owed. Depreciation is one of the most significant expenses, which allows you to deduct the property’s value from the annual income over 27.5 years.

All of these expense deductions are also available for a second home. However, the expenses must be prorated based on the time you rented it.

One way to avoid paying capital gains tax when you generate income from a second home is by renting it for 14 days or less each year. You do not have to report rental income on your taxes if you only rent your home for this short period each year.

Benefits of an Investment Property

One of the primary benefits of classifying a house as an investment property instead of a second home is its flexibility. Instead of worrying about using it enough time each year, you can rent it the entire year and enjoy the income. Of course, you will also be able to buy a duplex or four-plex if that’s what you’re looking for.

As we mentioned, many mortgage lenders will allow you to offset the mortgage payment with the rental income when looking at your debt-to-income (DTI) ratio on an investment property. They will typically give you credit for 75% of the gross rent because they know some of it will go toward management, maintenance, and vacancies. However, 75% of the rent should cover the mortgage payment on most rental houses.

Classify it Properly

Classifying property as a second home can provide many advantages, especially when getting a loan. However, it would help if you never tried to take advantage of these benefits and squeeze a traditional investment property into this category.

First, you will have difficulty getting through your lender’s underwriting process if you are not straightforward with them. Also, if you convince them that you will be using it as a second home and then begin renting it for the entirety of the year, you could be charged with mortgage fraud.

However, suppose your property easily qualifies as a second home, and you can afford the extra payment on your debt-to-income ratio. In that case, you should classify it as such and enjoy the benefits.

What is Better? A Second Home vs Investment Property?

Honestly, what works best for you will be based on your situation and goals. For example, if you are looking to buy a vacation home in an area you frequently travel to and have enough income to absorb the extra debt, a second home will likely be your best option. But if you’re looking for an asset that can generate rental income and want flexibility, you should probably stick to an investment property.

We hope this has given you some clarity on the topic of second homes vs investment properties. No matter your next real estate purchase, we hope it is a great one! Speak to a seasoned real estate agent familiar with the area to help you buy a second home.