In California it is not uncommon for homeowners to own more than one property. Mountain cabins, beach houses, and vacation homes are part of the lifestyle. However, when it comes to getting a legal or financial edge, it can sometimes be hard to know how to classify the property. Here is a basic overview of some common property types and how to tell them apart.
A primary residence is the main home that someone inhabits; they can also be referred to as a principal residence or main residence and can be a variety of dwelling types. Homes, apartments, boats, and trailers can all be considered a primary residence as long as it is where an individual, couple, or family resides the majority of the time. California defines a primary residence as “the place where you voluntarily establish yourself and family, not merely for a special or limited purpose, but with a present intention of making it your true, fixed, permanent home and principal establishment.”
If your primary residence is in California then you are taxed on all of your income, even if the income comes from a source outside the state. On the other hand, if you are a part-time resident you are taxed only on income you receive when living in California, or income received from California when you are residing out of the state.
A primary residence typically has the lowest interest rates and you can only claim one property as a primary residence. According to the IRS, the property needs to meet some basic requirements in order to qualify as a primary residence. We already established that you must live in the home for most of the year, however, the IRS will take into consideration other factors as well. Examples of this include:
- The property where you receive most of your mail
- The address that is listed on your tax returns
- The address listed on your driver’s license
- The address on your car registration
- If the residence is a convenient distance from your place of employment
- The proximity of the home to where children in the family attend school
- The district where you are registered to vote
They will also want additional documentation to prove your residence, such as utility bills, voter registration, and tax returns. Once you have established a property as a primary residence it is likely to be eligible for several tax deductions. For example, homeowners can deduct mortgage interest on loans up to $750,000 on both primary and secondary residences. You can also claim your mortgage insurance payments if you purchased your home after 2006. If you are married, you can still only classify one property as your primary residence; your spouse must claim the same property as their primary residence as well. If you plan to turn the property into an investment or rental property within 6 months of closing, you cannot classify it as a primary residence. The location of your primary residence can have a dramatic effect on your tax status, but the bottom line is that you can only claim one property as your primary residence.
A second home is a property that you live in for part of the year or visit on a regular basis. This is what you would think of as a vacation home and the main distinction that separates it from an investment property is that the home is not primarily intended for generating income. This means that there are several restrictions to claiming a property as your second home.
To start, in order to claim the property as a second home it must be exclusively under your control and not subject to a rental, time-share, or property management agreement. The home must also be a reasonable distance from your primary residence. Since there are not many reasons to own a second home in the same area as your primary residence, many lenders will want it to be at least 50 miles away. In addition, the property will need to be accessible by car year-round.
Someone other than you can live in your second home, however you need to live there more than the tenant. Many lenders will limit how long a tenant can live at the property. In California you can rent the property for up to two weeks tax-free no matter how much time you live in the property. However, if you rent for 15 days, or more you will have to claim the income.
If you rent the home you may be able to deduct certain things that are considered rental expenses. When renting a second home it is important to spend a minimum of 14 days at the residence or more than 10% of the days when you would normally rent it out, whichever is greater. Finally, the home cannot be rented out for more than 180 days in the year. If the time you spend at the property doesn’t fit these criteria, then the home will lose its second home distinction and need to be classified as an investment property. You may want to ensure that the house remains eligible for second home status since it will provide you with a mortgage interest tax deduction.
An investment property is real estate property purchased with the intention of generating income.
The income from an investment property can come from rental income, the future resale of the property, or both. When it comes to residential real estate it is common for these properties to be rented out as a primary residence or a vacation rental, although there has been a sharp increase in the number of homes in California being flipped for a profit. Investment properties can be single family homes or condos, as well as multi-unit properties.
An investment property will usually require a much larger down payment than a primary or secondary home, and the property will be subject to more restrictions. Mortgage rates will also be higher on this type of property due to the higher risk a lender is taking on. For tax purposes, an investment property is any property that is rented out for more than 180 days out of the year, that is not occupied by the owner, and is only used to generate income. All income generated from investment properties in the state of California must be reported on your tax returns, although the owner can deduct expenses related to the cost of maintaining the property.