Primary Residence: What Is It And Why Is It Important?
Victoria Araj4-minute read
May 15, 2021
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.
Primary Residence, Defined
Your primary residence (also known as a principal residence) is your home. Whether it’s a house, condo or townhome, if you live 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.
What Primary Residence Means For Your Mortgage
When you apply for a mortgage, the type of home property you’re financing – primary home, second home or investment property – will have an impact on 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 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.
Capital Gains On A Primary Residence
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 time frame 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.
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 (aka 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.
Still have questions? Speak with a Home Loan Expert.
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