Vacation Home vs. Investment Property: What’s the Difference?
- Encompass CRM
- 8 hours ago
- 3 min read
There are a number of reasons to purchase a second home: as a family getaway, to build equity, or to have a future retirement home, among others. And with the rise of online marketplaces like Airbnb and Vrbo, it’s easier than ever to rent out a second property for additional income. It feels like the perfect combination of business and pleasure … and it can be!
But here’s where it gets tricky: If you’re buying a second home that you intend to rent out, is it considered a second home or an investment property? That distinction is important, because it impacts your mortgage terms, interest rate, tax liabilities, and more. Let’s explore the differences between these two home types.
Vacation Home
In simple terms, a vacation home (aka second home) is a residence you plan to occupy for at least part of the year. You can rent it out when you’re not using it, but the rental income cannot be used to help you qualify for the loan.
Property guidelines*
You must occupy the property for a portion of the year. (It can’t be rented out full-time.)
You can’t use potential rental income from the home to qualify for a mortgage.
It must be a one-unit dwelling that is suitable for year-round occupancy.
You must retain exclusive control over the property, meaning it cannot be a timeshare, and rentals cannot be managed by a property management company.
The home must be a “reasonable distance” away from your primary home. Specific rules vary depending on the lender.
Lenders may have additional restrictions, including a limit on how many days you can rent out the home per year. Talk to your lender to understand all your options and limitations before committing.
Tax implications**
Keep in mind that, per the IRS, you’ll have to pay taxes on the rental income from the home if you rent it out more than 14 days a year.
You can deduct your rental expenses (such as mortgage interest payments, property taxes, advertising costs), but the amount you can deduct may be limited if you occupy the home for:
14 days, or
10% of the days you rent it out (whichever is greater).
The bottom line here is that the IRS doesn’t want to treat your property exclusively as a business if it is also being used as a residence. Talk to a tax professional to learn more about the tax implications of buying and renting a second home.
Mortgage criteria*
In general, it’s much easier to qualify for a loan on a vacation home than an investment property. When purchasing a vacation home, you’ll generally need:
At least two months of cash reserves (i.e., two months’ worth of mortgage payments on both your primary and second home)
Minimum 10% down payment
A credit score of 640 or higher
A debt-to-income (DTI) ratio of 45% or less
Investment Property
In contrast, an investment property is a dwelling you plan to rent out solely to generate income. Rental income from investment properties is also taxable, but unlike with vacation homes, you’re less restricted on deducting expenses related to upkeep of the property.*
Lenders consider investment properties to be at a higher risk for default, so it can be more challenging to qualify for a mortgage. The interest rate will likely be higher than for a primary or vacation home, but the lender may allow you to use projected rental income to help qualify for the mortgage. You can also expect to need:
At least six months of cash reserves
Minimum 20% down payment
A credit score of 640 or higher
A debt-to-income (DTI) ratio of 45% or less
Remember that when you purchase and finance a vacation home or investment property, you become responsible for two mortgages, two tax bills, two insurance policies, and two sets of utility payments, plus year-round maintenance. These types of properties can be expensive, but if your budget allows, they can be a smart — and fun! — investment.
*Applies to loans backed by Fannie Mae and Freddie Mac (conventional loans). Guidelines may differ for government-sponsored and non-conventional loans. Talk to your mortgage lender for their specific requirements.
**We are not a tax advisory firm. The information contained in this article is for informational purposes only and may not reflect current tax year rules and regulations. Consult your tax advisor or the IRS for current tax year rules, restrictions, and regulations.
Sources:
Internal Revenue Service, “Topic No. 415 Renting Residential and Vacation Property.” Fannie Mae, Originating & Underwriting Selling Guide, B2-1.1-01, Occupancy Types.
Freddie Mac Single-Family Seller / Servicer Guide, 4201.12, Second home Mortgages.
Fannie Mae, Originating & Underwriting Selling Guide, B3-4.1-01, Minimum Reserve Requirements.