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What is an Investment Property?

[Updated: Jun 15, 2020] Oct 19, 2019 by Matt Frankel, CFP
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What is an investment property? Obviously, it's a property that you hope to make money from, as opposed to owning for your personal use. But there’s more to it than that.

Here’s an overview of the general definition of an investment property as well as a couple ways to more specifically define the term. These definitions can have implications for taxes and financing.

What is an investment property?

When it comes to residential properties you own, there are three main classifications:

  • A primary residence is a home that you live in on a full-time basis. You don’t have to live there all year round, but it must be your main place of residence. A key principle to know is that you can only have one primary residence at any given time.
  • A second home is a property that you live in some of the time. A second home may or may not be rented out when you aren’t using it, and the precise definition of a second home depends on the context (like financing or taxes). You can have more than one second home -- it just means a home you use that's not your primary residence.
  • An investment property is a property that you own exclusively for generating rental income and/or an eventual profit on its sale. You typically won't use an investment property for personal use at all.

It’s also important to realize that a fix-and-flip is not an investment property. With these projects, you aim to sell quickly for a profit. An investment property is one you plan to hold for the purpose of generating income or long-term appreciation.

These are admittedly vague definitions. If you ask a real estate agent, a mortgage lender, and a tax attorney to define an investment property, you’ll likely get three different definitions.

With a lender, there may be a question of whether a property should be defined as a second home or investment property. The definitions of these terms can vary between lenders and we’ll get into why it matters later. The thing to know for now is that it’s often preferable to finance a property as a second home. if possible.

The IRS has a clear definition of an investment property. To call a property a second home or a personal residence for tax purposes, you need to occupy the property for a minimum of 14 days or 10% of the days the property is rented, whichever is greater. If your property doesn’t meet this minimum, it's an investment property in the eyes of the IRS.

Tax implications of an investment property

A personal residence or second home can qualify for the mortgage interest tax deduction. That's never available for investment properties. But investors can deduct their mortgage interest as an expense to help offset their rental income, which can be just as lucrative or even more so.

Investment property owners can take a depreciation deduction on their taxes each year. This deduction can be used on second homes but must be prorated based on the percentage of the time the property was rented versus owner-occupied.

One negative tax implication of investment properties is that you can’t exclude capital gains when you sell. In fact, investment property owners typically have to pay capital gains tax on all profits plus a separate tax on the depreciation deductions they’ve taken over their ownership period. This is called depreciation recapture.

On the other hand, investment property owners can use a strategy known as a 1031 exchange to avoid taxes on the sale of a property. In a nutshell, this involves using the proceeds from the sale of one investment property to acquire another. This strategy isn't available for primary residences or second homes.

If you want to learn more, check out my longer discussion on the tax differences between investment properties and second homes.

Financing an investment property

One other major distinction of investment properties involves financing. In general, it’s easiest (and most cost-efficient) to finance a primary residence, followed by a second home, with investment properties in a distant third position.

For starters, down payment requirements are typically higher when you finance an investment property. Primary residences can be financed rather easily with 5% down or less, while second home down payments are often in the 10%–20% range. Most lenders want at least 20%–25% to finance an investment property.

You can also expect to pay higher loan origination fees and interest rates when financing an investment property. It’s not uncommon to see rates that are several percentage points higher than those for a primary residence or second home.

If you’re buying a property that you only plan to rent out some of the time, it’s generally easier to finance it as a second home, if you can. The challenge is that lenders have different requirements for second home financing. Some won’t make second home loans on properties you plan to rent at all, while others have similar occupancy requirements to the IRS.

Having said that, there are some potential advantages to financing a property as an investment. For example, if the property has a documented rental history, you may be able to use that income to help you qualify for the mortgage. And there are specialty investment property lenders that don’t care about your other debts or income. They base their lending decisions on your credit history and the property’s cash flow.

What is an investment property? It depends on who and why you're asking

Generally speaking, you hold an investment property for the primary purpose of making money. You rarely (if ever) occupy it yourself. However, there's a specific definition of an investment property when it comes to taxes. Your lender might also have a strict definition that limits personal use of an investment property and rental use of non-investment properties.

The bottom line is that the precise definition of the term investment property depends on who you ask and why you're asking. Be sure to check your lender's requirements for financing, especially if you want to take advantage of second home financing. And be sure to consult a tax professional if you aren't sure if your property is an investment property in the eyes of the IRS.

Bonus read: See our article on the 9 best ways to invest in real estate.

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