Primary Residence: Definition And Impact On Your Mortgage And Taxes

When you buy a house, the way it’s classified matters. If you own multiple properties, you must understand the difference between a primary residence, a second home and an investment property. That’s because each of these properties qualifies for different types of home loans, loan terms and interest rates.

This article will explain what a primary residence is, and how it impacts your mortgage and taxes.

What Is A Primary Residence?

According to the IRS, your primary residence (or “principal residence”) is the home where you spend the majority of your time. It should be located near your place of employment, and be the home you use as your legal address.

When you’re buying a house, a primary residence qualifies for certain government-backed loans. It also has different tax implications from a second home or vacation home. Plus, your mortgage rates will be lower on a primary home since lenders consider it less of a risk.

A primary residence doesn’t have to be a single-family detached house. It can be an apartment, condo or townhome.

Primary Residence Rules According To The IRS

When evaluating you for a loan, your mortgage lender needs to know if it will be a primary or secondary residence. This will impact the terms of your loan. To ensure a home is used as a primary residence, lenders use standards set by the Internal Revenue Service (IRS). Here are the rules for primary residences according to the IRS:

• The home is where you spend the majority of your time.
• The address is on your driver’s license, voter registration card and both of your federal and state tax returns.
• It will be used as your mailing address.
• The home is close to your job, bank, the home of at least one of your friends or family members, a church or a gym.

Usually, these standards must be true for at least a year after closing on the house. That’s to ensure the house isn’t used as an investment property.

How Do Primary Residences Affect Mortgage Terms?

You’ll receive a lower interest rate on your mortgage for a primary residence than for a second home or investment property. Out of all the real estate properties you could buy, your primary home is considered the lowest lending risk.

Since you live there, your lender knows that will be the loan you’ll always try to pay first if you run into financial problems. That’s why lenders typically charge around 0.25% – 0.75% higher on interest rates for second homes and investment properties.

How Do Primary Residences Affect Income Taxes?

Your primary residence also comes with certain tax benefits, like the mortgage interest tax deduction. If you bought your home after December 16, 2017, you can deduct interest on the first $750,000 of mortgage debt on your tax return. If you’re married filing separately, you can deduct interest on the first $375,000 of mortgage debt.

How Do Primary Residences Affect The Capital Gains Tax?

When you sell a home that’s increased in value, you have to pay the capital gains tax. But when you sell your primary residence, you may qualify for the capital gains exclusion.

The capital gains exclusion lets homeowners exclude up to $250,000 if you’re a single filer, and up to $500,000 if you’re married filing jointly. Avoiding the capital gains tax can save you a significant amount of money on the sale of your home.

The 1031 Exchange

If you sell an investment property intending to buy another one, you can postpone capital gains taxes by doing a 1031 exchange. With a 1031 exchange, you’re trading one investment property for another with little to no profit. However, if you perform a 1031 exchange and later use that property as a primary residence, it won’t qualify for the capital gains exclusion when you sell it.

2-Out-Of-5-Year Rule

The IRS uses the “2-out-of-5-year rule” to determine whether you qualify for the capital gains exemption. This rule states you must have owned your home for at least 2 of the past 5 years, and it’s been your residence for that entire time. You also can’t have claimed any other capital gains exclusions in the past 2 years.

Primary Residence: FAQs

If you have additional questions about owning a primary residence, the answers to the following questions may help.

Is a primary residence the same as a principal residence?

Yes, a primary residence and a principal residence are the same thing. Both terms refer to the home you live in for the majority of the year.

Can a second home be considered a primary residence?

No, a second home can’t be considered a primary residence since you don’t spend most of your time there. A second home is usually purchased to live in for only part of the year. However, you can convert your second home into a primary residence by moving into it. You’ll need to update the address on your driver’s license, voter registration card and tax returns.

Can a married couple have two primary residences?

No, a married couple can have only one primary residence. Even if a married couple has two homes and splits time equally between those homes, they can only claim one primary residence. To determine which is the main home, the couple should do a “facts and circumstances” test.

What are the benefits of a primary residence?

When you take out a mortgage for a primary residence, you’ll qualify for lower interest rates which can save you a lot of money over the life of the loan. And your primary residence comes with certain tax benefits, like the mortgage interest tax deduction and capital gains exclusion.

Can I rent out my primary residence?

Yes, you can rent out your house, but you may need to notify your lender first. Since a primary residence qualifies for better terms and lower interest rates, some lenders have rules about whether you can rent it out. So, you’ll want to check your loan agreement to ensure you’re not inadvertently breaking the law.

How can I verify my primary residence?

There are a few different ways you can verify your primary residence. First, your primary residence is the home where you spend the majority of your time, which you can demonstrate with utility bills. You can also verify your primary residence using the address on your driver’s license, voter registration card and federal and state tax returns.

The Bottom Line

Before applying for a mortgage, it’s important to understand how the home you’re buying is classified. A primary residence comes with better terms, lower interest rates and certain tax benefits. If you’re ready to buy a home, you can start the approval process with Rocket Mortgage^® today.