Is a Second Home Considered an Investment Property?

The classification of a property as a second home or an investment property carries financial and tax consequences. How a property owner uses the real estate is the primary factor in determining its classification, which influences annual tax deductions and the financial outcome of a sale. The amount of time an owner personally uses the property versus renting it to others dictates its tax treatment for a given year.

Defining a Second Home for Tax Purposes

A property qualifies as a second home for tax purposes when the owner’s personal use is substantial and rental activity is minimal. For a property to be treated as a second home, the owner must use it for personal purposes for more than 14 days or more than 10% of the total days it is rented to others, whichever is greater. Personal use includes use by the owner, their family members, and anyone using the property for less than a fair rental price.

The primary tax benefits for a second home are deductions for mortgage interest and property taxes. Homeowners can deduct mortgage interest on up to $750,000 of total mortgage debt across their primary and second homes. Property taxes paid on a second home are also deductible, but this deduction is subject to the overall $10,000 limit on state and local taxes (SALT).

If a second home is rented out for 14 days or less during the year, the owner does not need to report the rental income to the IRS. This allows for a small amount of tax-free income. In this scenario, the property is treated as a personal residence for tax purposes, and no rental expenses, such as cleaning or maintenance costs, can be deducted.

Defining an Investment Property for Tax Purposes

An investment property is real estate purchased with the intention of generating income through rentals or profiting from its appreciation in value. If an owner’s personal use of the property does not exceed the thresholds that define a second home, it is classified as an investment property for that tax year. This classification shifts the tax focus from personal deductions to business-related ones.

When a property is treated as an investment, the owner must report all rental income received. The advantage of this classification is the ability to deduct a wide range of ordinary and necessary expenses associated with managing and maintaining the rental property to offset the rental income.

Commonly deducted expenses for an investment property include:

• Mortgage interest
• Property taxes
• Insurance premiums
• Fees paid to property management companies
• Advertising the property for rent
• Cleaning and maintenance between tenants
• Repairs to keep the property in good operating condition

A significant deduction for investment properties is depreciation, which allows the owner to recover the cost of the property over 27.5 years for residential rental real estate.

The Mixed-Use Classification Rules

When a property is used for both personal enjoyment and rental activities during the same tax year, the IRS provides specific tests to determine its tax treatment. The primary test hinges on the amount of personal use versus rental use, which directly impacts which deductions an owner can claim. This determination must be made annually based on the property’s use during that year.

The central rule for mixed-use properties is that if an owner personally uses the property for more than the greater of 14 days or 10% of the total days it is rented at a fair market price, it is considered a personal residence for that tax year. In this case, while the owner must report rental income, the deductibility of rental expenses is limited to the amount of that income. If personal use does not exceed this threshold, the property is treated as a rental property, allowing for the deduction of rental expenses, which could create a loss to offset other income, subject to certain limitations.

When a property is classified as a mixed-use personal residence, expenses must be allocated between personal and rental use. This allocation is based on the number of days the property was used for each purpose. For example, if the property was rented for 90 days and used personally for 30 days, 75% of the year’s expenses like utilities, insurance, and maintenance would be allocable to the rental activity.

Mortgage interest and property taxes have a specific allocation method. A portion of these expenses is allocated to the rental use based on the ratio of rental days to total days of use. The remaining portion is allocated to personal use and can be deducted as an itemized deduction on Form 1040, subject to the standard limitations for mortgage interest and state and local taxes.

Tax Consequences When Selling the Property

The tax implications at the time of sale differ depending on whether the property was used as a second home or an investment property. For a property sold after being used as a second home, the profit is treated as a capital gain. The gain is calculated as the selling price minus the owner’s adjusted basis (the original purchase price plus capital improvements) and is subject to long-term capital gains tax rates if held for more than one year.

Unlike a primary residence, a second home does not qualify for the home sale exclusion, which allows taxpayers to exclude up to $250,000 ($500,000 for joint filers) of gain from their income. This means the entire profit from the sale of a second home is taxable.

The sale of an investment property also involves capital gains tax, but with an additional consideration: depreciation recapture. The depreciation deductions claimed during ownership reduce the property’s adjusted basis, which increases the total gain upon sale. The portion of the gain attributable to depreciation is recaptured and taxed at a maximum rate of 25%.

Owners of investment properties can defer paying taxes on the gain through a Section 1031 exchange. This provision allows an owner to sell an investment property and reinvest the proceeds into a “like-kind” investment property within a specific timeframe. By doing so, the capital gains tax and depreciation recapture tax are deferred until the replacement property is sold.

Financing and Insurance Considerations

Beyond taxes, the classification of a property as a second home or an investment property affects financing and insurance. Lenders and insurance companies view the two types of properties differently, leading to variations in qualification requirements, costs, and coverage.

From a financing perspective, lenders consider investment properties to be higher risk than second homes, which translates into stricter lending criteria. Borrowers seeking a loan for an investment property should expect to make a larger down payment, often 20% to 30%. Furthermore, the interest rates on mortgages for investment properties are higher than those for second homes.

Insurance policies also differ based on the property’s use. A second home is covered by a standard homeowner’s insurance policy, similar to a primary residence. In contrast, an investment property requires a landlord or dwelling fire policy. These policies are designed to cover risks associated with rental activities, such as liability for tenant injuries and loss of rental income, and their premiums are often higher.