Can You Live in Your Investment Property?

Property owners may consider occupying a property initially acquired as an investment. This decision involves a complex reclassification of the property’s purpose. Changing a property’s designation from an investment to a primary residence triggers financial, legal, and tax implications. Understanding these changes is important to navigate the transition effectively.

Understanding Property Classification

Property classification hinges on intent and actual occupancy. A primary residence is defined as the dwelling where an individual lives for the majority of the year, serving as their main home. This is the address listed on official documents like tax returns, driver’s licenses, and voter registration. If an individual owns multiple properties, only one can be designated as the primary residence.

An investment property is acquired to generate income or for capital appreciation. Unlike a primary residence, personal occupancy is not the main purpose; the property is viewed as a financial asset.

Lenders and tax authorities distinguish between these classifications. For a primary residence, lenders expect the owner to move in within a certain timeframe and intend to live there for at least 12 months. For investment properties, the focus is on their income-generating potential, with less emphasis on owner occupancy. For example, the IRS may classify a property used personally for more than 14 days or 10% of the days it is rented out at fair market value as a second home, not a pure investment property.

Impact on Financing

Converting an investment property to a primary residence directly impacts the existing mortgage. Loans for owner-occupied properties feature more favorable terms compared to those for investment properties. Primary residence mortgages have lower interest rates, reduced down payment requirements, and higher loan-to-value (LTV) ratios. Lenders view primary residences as less risky because borrowers prioritize payments on the home they live in.

Mortgage agreements include an “occupancy clause” that mandates the borrower occupy the property as their primary residence for a specified period, often 12 months, following the loan’s origination. This clause prevents borrowers from obtaining a lower-interest owner-occupied loan and immediately converting the property to a rental, which is considered mortgage fraud. Violating this clause can lead to penalties, adjusted loan terms, or immediate repayment of the entire loan balance, potentially resulting in foreclosure.

Notify the mortgage lender about any change in occupancy. Failing to inform the lender can be considered a breach of contract. The lender may then adjust the loan terms to reflect the higher risk associated with a non-owner-occupied property, such as increasing the interest rate.

Tax Consequences of Conversion

Converting an investment property to a primary residence carries tax implications, particularly for capital gains and depreciation. When a property that was once a rental is eventually sold, the homeowner may be eligible for the primary residence capital gains exclusion under Section 121. This exclusion allows single filers to exclude up to $250,000 and married couples filing jointly to exclude up to $500,000 of profit from the sale of their main home. To qualify, the property must have been owned and used as the principal residence for at least two of the five years leading up to the sale.

However, the gain attributable to depreciation deductions taken while the property was a rental is not eligible for this exclusion and must be “recaptured.” Depreciation recapture is taxed at a maximum rate of 25%.

The property’s tax assessment and eligibility for certain exemptions can change. Upon conversion to a primary residence, the property may become eligible for a homestead exemption, which can lower property tax assessments. Homestead exemptions provide property tax benefits exclusively for primary residences. Apply for these exemptions with local tax authorities, as they do not automatically transfer.

The deductibility of expenses shifts. While the property was a rental, expenses like mortgage interest, property taxes, insurance, and maintenance were deductible against rental income. Once it becomes a primary residence, many of these deductions transition to personal itemized deductions on Schedule A, such as mortgage interest and real estate taxes, subject to personal income tax rules and limitations.

Steps for Changing Property Use

Several administrative steps are necessary to formalize the conversion of property use. Notify the mortgage lender about the change in occupancy. This ensures compliance with the loan agreement and allows the lender to adjust loan terms.

Updating insurance policies is an important step. Landlord or rental property insurance policies cover risks associated with tenants and income generation. Upon conversion, switch to a homeowner’s insurance policy, which covers owner-occupied risks.

Change utility accounts from tenant or landlord names to the new owner-occupant’s name. This ensures direct billing and responsibility for services like electricity, water, gas, and internet. Update mailing addresses with the U.S. Postal Service and other relevant institutions, and update voter registration.

File for any applicable local or state homestead exemptions for tax purposes and potential property tax savings. These exemptions require an application to the local tax assessor’s office and verification of primary residency. If the property has tenants, follow proper legal procedures for lease termination, including providing adequate notice as stipulated by the lease agreement and local tenant laws.