Can You Live in an Investment Property?

Converting an investment property to a personal residence involves various financial and administrative adjustments. This transition requires careful consideration of several factors. Understanding these implications can help ensure a smooth transition and avoid unexpected complications.

Lender and Loan Considerations

Lenders categorize properties as either primary residences or investment properties. This classification significantly influences key loan terms, including interest rates and down payment requirements. Loans for primary residences often feature lower interest rates and smaller down payments, sometimes as low as 3% to 5%, due to lower perceived risk. In contrast, investment property loans typically carry higher interest rates, often 0.5% to 1% higher than primary residence mortgages, and usually require larger down payments, commonly ranging from 20% to 25%. Lenders view investment properties as having a higher risk of default, as borrowers may prioritize payments on their primary home during financial difficulties.

Many mortgage agreements for primary residences include an “owner-occupancy clause,” which stipulates that the borrower must live in the property as their main home for a specific period, typically 6 to 12 months after closing. If a borrower violates this clause, it can be considered mortgage fraud, potentially leading to penalties such as fees, an increase in the interest rate, or even the lender demanding full repayment of the loan. In severe cases, foreclosure proceedings could begin.

Notifying your lender about a change in occupancy is an important step. Some loans, like Home Equity Lines of Credit (HELOCs), may have clauses allowing the lender to call the balance due if property use changes. The lender may require a loan modification or even a refinancing of the mortgage to align with the new occupancy type, reflecting the higher risk associated with a non-owner-occupied property. Changes in occupancy status can also impact a borrower’s future borrowing capacity or eligibility for other loans, as their current mortgage terms are tied to the property’s classification.

Tax Implications

Converting an investment property to a primary residence significantly alters its tax treatment. As an investment property, expenses such as mortgage interest, property taxes, insurance premiums, maintenance, and property management fees are generally deductible against rental income. Upon conversion to a primary residence, these specific rental-related deductions are no longer applicable. However, as a homeowner, you may become eligible to deduct mortgage interest and property taxes as itemized deductions, provided you meet the requirements for itemizing.

A key consideration is depreciation recapture if the property was previously depreciated as a rental. Taxpayers are required to “recapture” depreciation deductions taken during the rental period, meaning this amount is taxed upon sale, even if the property later qualifies for a primary residence exclusion. The recaptured depreciation is typically taxed at ordinary income rates, capped at 25%.

The capital gains tax treatment also changes when an investment property becomes a primary residence, particularly regarding the Section 121 exclusion. This exclusion allows eligible homeowners to exclude up to $250,000 of capital gains ($500,000 for married couples filing jointly) from the sale of their primary residence. To qualify, the taxpayer must have owned and used the home as their primary residence for at least two out of the five years preceding the sale.

However, a “non-qualified use” period can limit the Section 121 exclusion. If the property was used for purposes other than a primary residence after 2008, the gain attributed to those non-qualified periods may not be excludable. The excludable gain is prorated based on the ratio of qualified use to the total period of ownership. For example, if a property was a rental for three years and then a primary residence for two years before sale, a portion of the gain corresponding to the rental period would be taxable. Local jurisdictions may also offer homestead exemptions, which can reduce property taxes for owner-occupied homes.

Insurance and Property Management Adjustments

Changing a property’s occupancy from an investment to a primary residence necessitates a switch in insurance coverage. Landlord insurance is specifically designed for rental properties. It covers the physical structure, loss of rental income if the property becomes uninhabitable, and liability protection for incidents involving tenants or visitors. Homeowner’s insurance, conversely, is for owner-occupied properties and covers the building, personal belongings, additional living expenses if displacement occurs due to a covered event, and general liability.

A standard homeowner’s policy typically does not provide adequate coverage for a property used as a rental, as the risks associated with tenants are different and generally higher. Therefore, when you move into a property that was previously rented, it is important to contact your insurance provider to convert the landlord policy to a homeowner’s policy. Landlord insurance is generally more expensive than homeowner’s insurance due to the increased risks involved with tenant-occupied properties, so changing policies can potentially result in a decrease in premiums.

Ending property management duties is another significant adjustment. If the property was managed by a third-party company, their services will no longer be needed, requiring the termination of any existing contracts. For properties previously managed directly by the owner, responsibilities like collecting rent and coordinating repairs will cease. This transition also means the owner assumes full responsibility for property upkeep and management. Homeowners’ association (HOA) rules or local ordinances might also have different stipulations for owner-occupied versus rental properties, which could impact available amenities or require adherence to new regulations.

Formalizing the Occupancy Change

Formalizing the conversion of an investment property to a primary residence requires several procedural steps. A primary step involves informing the mortgage lender about the occupancy change. You may need to provide specific information, such as your new mailing address and the date you moved into the property.

Next, update the property’s insurance coverage by contacting your provider to switch from a landlord to a homeowner’s policy. It is advisable to secure the new homeowner’s policy before canceling the old one to avoid any lapse in coverage. You should then send a copy of the new homeowner’s insurance declarations page and the cancellation notice for the former policy to your mortgage lender, especially if your insurance payments are handled through an escrow account.

If the property was previously rented, a crucial step involves transitioning out any existing tenants. This includes providing tenants with proper notice as required by lease agreements and local landlord-tenant laws, which range from 30 to 90 days. Ensuring a smooth departure for tenants, including the return of security deposits, helps avoid future disputes. Finally, updating official records with relevant authorities is important. This includes notifying the local property tax assessor’s office of the change to reflect the primary residence status, which could impact property tax assessments or eligibility for homestead exemptions.