What Constitutes an Investment Property?
A property's classification is defined by its use, not just its type. This distinction governs the specific tax and financing rules that will apply.
An investment property is a piece of real estate acquired with the express purpose of generating a financial return. This return can be realized through rental payments from tenants, a profit from a future sale, or a combination of both. Unlike a primary home, the owner does not occupy an investment property as their main dwelling, making it a business asset rather than a personal one.
Core Criteria for Classification
The classification of a property as an investment is not limited by its structure. It can apply to residential properties like single-family homes and multi-family apartment buildings. The classification also extends to commercial real estate, such as retail storefronts, office buildings, and industrial warehouses. Even undeveloped land can be an investment property if held with the expectation of a future profit.
The way an owner interacts with the property provides evidence of their intent. Actively marketing a property for rent, engaging a property manager, and maintaining separate financial records are all indicators of investment intent. These actions demonstrate a business-like approach to property ownership.
This distinction carries significant consequences for how the property is treated for tax and financing purposes, setting it on a different path from a personal residence.
Differentiating from Personal Use Properties
The line between an investment property and a personal residence can blur with vacation or second homes that are both used by the owner and rented out. The Internal Revenue Service (IRS) provides guidelines to distinguish between these uses based on the allocation of personal versus rental days. These rules determine how income and expenses are reported for tax purposes and are often called the “14-day rule” or the “10% rule.”
Under IRS rules, a property is considered a residence if the owner’s personal use exceeds the greater of 14 days a year or 10% of the total days it is rented at a fair market price. For example, if you rent a cabin for 200 days and use it for 15 personal days, your personal use is less than 10% of the rental days (20 days), classifying it as a rental property.
Conversely, if you rent that cabin for 100 days and use it personally for 25 days, your personal use exceeds both thresholds. In this scenario, the property is classified as mixed-use, requiring a more complex allocation of expenses. Personal use days include any days the property is used by the owner, their family, or anyone for less than fair rental value, but days spent on maintenance do not count.
A provision known as the “Augusta Rule” applies if you rent out your home for 14 days or less per year. In this case, you do not report the rental income, but you also cannot deduct rental expenses. This can be advantageous for homeowners near major events who can command high short-term rental rates.
Tax Treatment of Investment Properties
Once a property is classified as an investment, its tax treatment differs from that of a personal residence. All rental income, including fees for pets or cleaning, must be reported to the IRS on Schedule E (Form 1040). This income is added to your other income and taxed at your regular rates.
A financial advantage of owning an investment property is the ability to deduct ordinary and necessary expenses. These deductions reduce your net rental income, lowering your overall tax liability. Common deductions include:
- Mortgage interest
- Property taxes and insurance
- Maintenance and repair costs
- Fees paid to property management companies
- Marketing and legal fees
- Travel costs related to property management
Depreciation is a non-cash deduction that allows you to recover the cost of the building, but not the land, over its useful life. For residential rental properties, the depreciation period is 27.5 years. This deduction can create a taxable loss on paper even when the property generates positive cash flow.
When you sell an investment property for a profit after holding it for more than one year, the gain is subject to long-term capital gains tax, which has lower rates than ordinary income. A Section 1031 exchange allows an owner to defer paying this tax by selling one investment property and reinvesting the proceeds into a “like-kind” property within a specific timeframe.
Financing and Mortgage Considerations
Obtaining a mortgage for an investment property is different than financing a primary residence because lenders view these loans as having a higher risk. In times of financial hardship, a borrower is more likely to default on an investment property loan than on their own home mortgage, which influences the loan terms.
To compensate for this risk, lenders require a larger down payment. While a primary home may be purchased with as little as 3-5% down, lenders often require at least 15% for a single-unit investment property and 25% for properties with two to four units. More equity from the start reduces the lender’s potential loss in a foreclosure.
Interest rates for investment property loans are also higher than for primary residences, often by 0.25% to 0.875%. Lenders will also have stricter qualification criteria. Borrowers often need a higher credit score, a lower debt-to-income ratio, and significant cash reserves to be approved for an investment property mortgage.