Deciding to purchase a second home is just as life-changing as the decision to buy your first home. Maybe you want a condo closer to the mountains, a house down south near the beach, or somewhere not too far away where you can spend long holiday weekends. Perhaps you want to generate extra income, and you’ve been waiting for the right time to purchase a rental property. There are many options available, and they’re not that difficult to finance.
To ensure your second home purchase is a lucrative investment, let’s review some mortgage and tax basics, so you’re financially prepared.
Investment or vacation home?
First things first, you need to consider your goals. Many don’t know that investment and vacation properties are financed differently. If you can qualify for your purchase without the property generating any income, buy it as a vacation home because you’ll be getting a better interest rate. Plus, qualifying for it is more straightforward when rental income isn’t in the mix.
If you need to rent out your second property to afford it, then it becomes an investment property, not a second home. Your lender will expect an appraisal with a comparable rental schedule. This document tells the underwriter what the property can potentially produce income wise.
The tax implications of a second home largely depend on the type of property you buy and how you use it.
If you plan to occupy your second home for more than 14 days per year or more than 10% of the time it's rented, the IRS categorizes it as a vacation home. If you occupy the property for less than IRS minimums or not at all, it’s classified as an investment or rental property. The ways you use or occupy the second home usually defines the property category for tax purposes in the eyes of the IRS.
Some people dream about, and others save for, vacation homes — somewhere to gather with extended family, and oftentimes, somewhere to retire to. Vacation homes that you never rent out are considered personal property, just like your primary residence. You can claim the mortgage interest deduction on your personal home and one vacation home. Though if you’re lucky enough to have more than one vacation home, you can write off property taxes on both (or all) of them. Keep in mind, property tax assessments for special projects, like new street lights on your road or freshly paved streets, aren't deductible.
What does it take to get into a vacation home? Expect to have two months of financial reserves and a competitive credit score, as credit requirements are often higher for a second home than a primary residence.
Investment properties are treated as investment real estate. This means that you are not limited as to how much interest you can write off in your taxes. You report your income and expenses from your rental homes on the Schedule E form, which lets you deduct just about every fee that you incur in owning the investment property. The only thing that you pay taxes on is the profit that you earn on the second home after expenses. If you lose money on the investment property, you can use that loss to offset income from other investment real estate properties or claim up to $25,000 of the loss against other income.
Just be sure to file the appropriate taxes for any rental income you get from your second home to avoid IRS penalties. You might need to consult a tax accountant for the best advice for those with rental income.
What does it take to get into an investment home? Since it’s tough to get mortgage insurance on an investment home purchase, you almost always need to make a 20% down payment.
Second home financing
Primary home cash-out refinance
If you have built up significant equity in your primary home, you can complete a cash-out refinance to access that equity as cash. That cash can provide you with a substantial down payment, which allows for a much more affordable second mortgage.
Lenders generally will allow cash-out refinancing equal to 80 percent of your equity. They will see a property value of $275,000 and subtract 20 percent ($55,000). That will leave around $220,000. This money will be used to first repay the existing loan of $85,000. The balance – $135,000 – represents the cash available to the borrower.
A conventional loan is the best loan program for financing your second home. This loan type is a mortgage that is not guaranteed or insured by any federal government agency such as the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA) or the US Department of Agriculture (USDA). A convention or “conforming” loan follows guidelines set by Fannie Mae and Freddie Mac.
Conventional loans can be used to buy vacation homes and investment properties that are anywhere from one to four units. They also offer some of the lowest down payments available, letting you get into a home with as little as 3% down. If you make a 20% or more down payment, then there are no private mortgage insurance (PMI) payments! Finally, conventional mortgages have flexible loan terms; you can select any repayment period between 8 and 30 years.
Some caveats apply to conventional loans for second homes. Such as the second home cannot be located within 50 miles of the primary residence, for example. Understandably, it’s best to speak with an experienced salary-based mortgage consultant like the ones at American Financing to go over all the features and requirements of your conventional loan.
Before finalizing your decision
Something you need to do at the beginning of your home search process — and once more, the very end — is to ask yourself, “why do I want a second home?” You’ll also need to thoroughly research local resale values, economic trends, tax rates, and amenities. As with any real estate transaction, don’t fall in love with a property without knowing exactly what you are getting into.