What are the two primary types of deductions a homeowner who holds a primary residence is permitted to take?

Buying a home? Knowing what type you’re buying is important.

How the home you purchase is classified can affect your taxes and the mortgage interest rate that you receive. The property you purchase can be classified as a primary residence, a secondary residence, or an investment property.

The difference between these three is important to know when buying a house. How your new home is classified could end up saving or costing you a lot of money.

Your primary residence (also known as a principal residence) is your home. Whether it’s a house, condo or townhome, if you take up occupancy there for the majority of the year and can prove it, it’s your primary residence, and it could qualify for a lower mortgage rate.

Your primary residence may also qualify for income tax benefits: both the deduction of mortgage interest paid as well as the exclusion of profits from capital gains tax when you sell it. Because of the tax benefits, the IRS set some clear guidance to help you determine if your home qualifies as a primary residence.

The Rules Of Primary Residence

If you own one home and live in it, it’s going to be classified as your primary residence. But if you live in more than one home, the IRS determines your primary residence by:

• Where you spend the most time
• Your legal address listed for tax returns, with the USPS, on your driver’s license and on your voter registration card
• The home that is near where you work or bank, recreational clubs where you’re a member or other family members’ homes

These are simple tests, but it can get more complicated for a homeowner who has more than one home.

When you apply for a mortgage, the type of home property you’re financing – primary home, second home or investment property – will impact the mortgage rate you receive. Typically, mortgage rates are lower for primary residences.

A lower mortgage rate can save you a lot of money in interest payments over the life of the loan. If you’re applying for a mortgage for your primary home, it’s important that your lender knows this so they offer you the appropriate rate for the type of property.

The same rule applies to refinancing your primary residence’s mortgage. Before choosing which type of refinance you’d like to apply for, to your lender about the option that will best suit your needs. 

The interest that you pay on your mortgage on a primary and secondary residence may also be tax-deductible, up to a limit. As a rule, that began in tax year 2018, taxpayers can deduct up to $750,000 of mortgage interest on a home. To deduct mortgage interest, you’ll need to itemize deductions using Schedule A of Form 1040.

Understand the details to have a successful purchasing or refinancing experience.

A tax break for the mortgage interest you paid isn’t the only benefit that comes with owning a primary residence. You may also qualify to exclude capital gains when you sell your home.

Capital gains tax is what you pay when you sell an asset that has increased in value. When you decide to sell your primary residence and it has increased in value, you’ll be eligible to exclude some of the capital gains from the proceeds of your sale. Currently, the IRS allows taxpayers to exclude up to $500,000 in capital gains if married filing jointly or $250,000 if single.

Let’s say you purchase a home for $200,000. It’s your primary residence and the only home you own. A few years later, you decide to move and sell it for more money. After paying for costs related to the sale, your profit is $50,000. If you meet the criteria for the exclusions, you won’t have to pay capital gains taxes on that profit. The capital gains tax rate is 0%, 15% or 20% depending on your income.

To qualify for the exclusion,

• You must have owned your home for at least 24 months out of the previous 5 years.
• It must have been your primary residence for at least 24 months out of the previous 5 years.
• You can’t have claimed another capital gains exclusion in the past 2 years.

The 1031 Exchange

There is an exception to the capital gains exclusion, and it relates to property that was previously purchased through a 1031 exchange. If you own an investment property and you want to sell it and purchase another investment property, you can defer paying capital gains tax on the sale if you do a like-kind exchange (a 1031 exchange).

During a 1031 exchange, you’re selling one investment property and within a certain period purchasing another investment property that is like-kind.

But what if you eventually move into that investment property and convert it to your primary residence? And then want to sell it? The property that you acquired through the 1031 exchange isn’t eligible for the capital gains exclusion if you sell it within 5 years of purchasing it.

Even if you purchase a home with the intention of treating it as your primary residence, plans can change and you might find yourself wanting to rent it out. If you’d like to convert it into a rental property, you’ll need to contact your mortgage lender. Additionally, it’s wise to familiarize yourself with the tax implications of renting out your primary residence to ensure it’s a venture you can realistically afford.

Can a second home be considered a primary residence?

“Primary residence” and “second home” are two separate categories of property classification. If a property is legally regarded as your second home, it ican’t be your primary residence. Your primary residence must be where you spend the majority of your time.

Can you have two primary residence mortgages?

No, you cannot legally have two primary residences. Even if you split your time equally between two places or in between places while relocating for work, the IRS requires you list one property as a primary residence while filing taxes.

Before you buy a home, it’s a good idea to understand what type of home you’ll be buying. Are you planning to buy a primary residence (a.k.a. a principal residence), a secondary residence or an investment property?

These are important considerations that will affect the type of mortgage rate you may qualify for, as well as the tax treatment of your mortgage interest payments and any gain you make when you decide to sell. Knowing which property of yours would be considered your primary residence is essential information whether you’re purchasing a new home or refinancing your current one.

Ready to begin your home buying or refinancing journey? Get approved with Rocket Mortgage® today!