Primary residence: What it is and why it’s important

There are a lot of things to think about when it comes to homeownership. Handling the mortgage payments, buying insurance, doing yard work, and keeping the house maintained are all things you need to keep in mind. There are also legal and tax ramifications to consider.

One concept that’s important for mortgage and tax purposes is the idea of a primary residence. Your primary residence is the home that you live in for most of the year, so if you have a house you live in for 9 months a year and a summer home, the place you live for 9 months is your primary residence.

Often, there are tax benefits for having a primary residence such as deducting mortgage interest, and you may get a better deal on a loan for a primary residence, so understanding how these rules work is important.

Primary residence definition

A primary residence, also known as a principal residence, is generally the home that you live in for most of the year. You can only have one primary residence, so you can’t live in two homes an equal amount of time and have them both be your primary residence.

Your primary residence can be any kind of property, such as an apartment, condo, or single-family home.

Typical non-primary residences include investment and rental properties, second homes, or vacation homes that you may own.

Primary residence rules

In general, the home that you live in most of the time is your primary residence. The IRS has a more precise definition:

“If you own and live in just one home, then that property is your main home. If you own or live in more than one home, then you must apply a "facts and circumstances" test to determine which property is your main home. While the most important factor is where you spend the most time, other factors are relevant as well.

“The factors of a property that is more likely to be your primary residence are:

The address listed on your:

• U.S. Postal Service address,
• Voter Registration Card,
• Federal and state tax returns, and
• Driver's license or car registration.

The home is near:

• Where you work,
• Where you bank,
• The residence of one or more family members, and
• Recreational clubs or religious organizations of which you are a member.”

While figuring out your primary residence is easy if you have one home, it becomes more complex if you have two.

There are also rules regarding renting out your primary residence. For your home to be a residence, you must live in it for the greater of 14 days or 10% of the days you rent it out. If you rent your residence out for fewer than 15 days a year, you do not need to report the rental income or expenses on your taxes.

Why a primary residence matters for your mortgage

In general, interest rates for purchase loans for a primary residence than for buying a second home or investment property. The same is true for refinancing a home that is your primary residence as opposed to refinancing a second home or investment property. In some cases, such as with government loans through the FHA, VA or USDA,  you can only use the loan when buying a primary residence.

Depending on where you live, you may also be eligible for a tax break for your primary residence. For example, Boston, Massachusetts, allows homeowners exempt a portion of their home’s value when determining their property tax bill on their primary residence.

If you take advantage of the mortgage interest deduction, you may only take it for interest charged on the loan for your primary residence. You may deduct interest only on up to the first $750,000 in mortgage debt ($375,000 if married filing separately).

Capital gains tax on a primary residence

When you sell your home, hopefully, you sell it for more than you paid to purchase it. If you do, you may owe capital gains taxes on the profit that you made. Capital gains taxes are taxes charged on the profit you make from investments, and the rate can vary from 0% to 20% depending on your filing status and income.

The formula determining your tax bill is:

(Sale price – (purchase price + cost of additional investments)) * tax rate = taxes

If you sell your primary residence, the IRS offers a tax break on the gains. Under IRS rules, you can exclude the first $250,000 ($500,000 if married, filing jointly) in gains from your taxes. In other words, if you earn a profit of less than $250,000 ($500,000 if married, filing jointly), you pay no capital gains taxes.

For example, imagine you purchase a home for $500,000, live there for three years, and make no major improvements, then sell it for $700,000. You’d owe no tax on the gains if you qualified for the tax break. If you did not live in it as a primary residence for at least two years, you’d owe taxes on the $200,000 in profit, which could be as much as $40,000 at the top capital gains rate.

Depending on any capital improvements you make or losses due to property damage, your cost basis or total value of the home for tax purposes could increase. When this happens your taxable profit and the capital gains tax you owe decreases.

Qualifying for a capital gains tax break

To qualify for the capital gains tax rate, you must meet the IRS’s requirements.

The tax break is only available for your primary residence, so to qualify, you must have used the home as your primary residence for at least two of the five years prior to the sale. You also cannot have used the capital gains exclusion on the sale of another home in the past two years.

There are exceptions to the primary residence rule for members of the military and other government agencies who are living far from home based on government orders.

The exact rules for qualifying for the tax break can be a bit complex. For example, if you buy a home and live in it for a year, then sell it, you will not qualify because you did not live there for two years out of the last five. If you sold after three years, you could be eligible.

Consider speaking to a tax professional if you have a complicated living situation that could make it hard to determine if you’re eligible for this tax break.

The 1031 exchange exception

If you can’t qualify for the capital gains tax exclusion on the sale of a home, you may be able to qualify for a 1031 exchange, which can reduce the taxes you owe.

A 1031 exchange lets you swap one investment property for another and defer the capital gains taxes.

For example, imagine you buy a rental home for $400,000, then sell it for $500,000, you’d typically owe capital gains tax on the $100,000 in profit. If you turn around and use those funds to buy a home for $500,000, you could instead defer the capital gains taxes until you sell the new home. However, you’d have to calculate taxes on a future sale of the new home as if you’d paid $400,000 for it rather than $500,000.

There are a lot of rules regarding 1031 exchanges. For example, you can’t use them for primary residences or second homes, only investment properties. The two properties exchanged must also be similar, you must hold the funds from the sale in escrow and use them for the new purchase, the transaction must happen within 180 days, and you can only use a 1031 exchange once per 5 years.

Because of the complexity of 1031 exchanges, it’s a good idea to consult a tax professional for help.

FAQ

Whether your home qualifies as your primary residence can have a lot of tax and mortgage implications, so it’s important to understand what makes a home your primary residence.

Can I rent out my primary residence?

Yes, you may be able to rent your primary residence on a limited basis. Consider consulting a tax professional for advice on how often you can rent your home without it losing primary residence status.

Can a second home be considered a primary residence?

Your primary residence is the home where you live for most of the year, so a second home cannot be a primary residence. If you wind up changing where you live for most of the year to your second home, it will become your primary residence, but your first home will no longer be your primary residence.

Can I have two primary residence mortgages?

It is only possible to have one primary residence, so you can only have one primary residence mortgage, even if you’re buying two homes. Recall that IRS rules require that you designate one home as a primary residence, even if you have to travel or move temporarily for work.

Though you can only have one primary residence, generally speaking, it is possible to qualify for a primary residence mortgage on a second property if you’re moving for a job or another significant lifestyle change. You would need to explain your circumstances to your lender and typically need to move into the new house within 60 days. The lender would also have other requirements related to income, DTI and credit score, among other things. If you anticipate needing to purchase a new primary residence while already owning a home with a primary residence mortgage you should speak to a lender about how to proceed.

How does the IRS verify my primary residence?

The IRS uses a few factors to verify your primary residence. For example, the IRS will check the address on your tax return, your voter registration, and where your home is compared to your employer.

If the IRS can’t verify that a home is your primary residence, it may ask for supporting documents or other proof. For example, if you can produce credit card records showing purchases near your primary residence for most of the year or other evidence that you were living in that home for most of the year, it can help the IRS verify your claim.

How can I avoid paying capital gains taxes on my primary residence?

To avoid paying capital gains taxes on your primary residence, do your best to qualify for the capital gains exclusion. For the most part, that means making sure you live in the home as your primary residence for at least two of the five years prior to selling it. To further reduce potential taxes, make sure to add the cost of any improvements you’ve made to the home to your cost basis when determining your gain.

The bottom line: Your principal residence can positively impact your finances

Your home being your principal residence can be very important when it comes time to pay your property tax bill, get a mortgage, or file your taxes with the IRS. For most people, figuring out their primary residence is easy. It’s the one home you own and live in. If you have multiple homes, it can be trickier, but the easiest rule of thumb is that your primary residence is the one you live in for most of the year.

If you’re ready to buy your first (or second) home, apply for a mortgage with Rocket Mortgage^®.