A primary residence is a home that you live in a majority of the time. Understanding the official primary residence definition and how lenders and the IRS classify different property types prepares you for the tax and financial implications of property ownership.
What is a primary residence?
A primary residence, also known as a principal residence, is the main place where you live. This doesn’t necessarily have to be a house — it can be an apartment, condo, townhome, mobile home, or even your boat. As long as it’s considered the place where you live and spend the majority of your time, it’s a primary residence.
The difference between a primary residence vs. an investment property is that buying a principal residence tends to qualify you for lower mortgage rates and most conventional and government-backed mortgages. Mortgages for investment properties and vacation homes tend to have higher rates and more stringent borrowing guidelines.
Plus, owning a primary residence can also come with perks like income tax benefits. Depending on how you file your taxes, you may be able to deduct the mortgage interest paid. You might also be able to exclude the profit you make on the sale of your primary residence from capital gains tax.
Because of the tax advantages involved in owning a primary home, the IRS has set clear rules as to what defines a primary residence.
Primary residence rules: IRS definition of primary residence
If you own one home, then the IRS counts that as your primary residence. It’s possible to own more than one residence, but only one can be counted as the principal residence. That’s where the IRS eligibility test comes into play.
More specifically, here are the IRS primary residence rules:
- Live most of the time on the property you own.
- The legal address needs to be listed on government issued IDs (such as your driver’s license and voter registration card), tax returns, and the USPS.
- The property is close to where you work, bank, other family members’ homes, or religious organizations or recreational clubs where you’re a member.
Complications may arise if you rent out your home. In this case, to qualify the property as your main residence, you’ll need to live in the home more than half of the time in a calendar year if you’re renting the property out or live elsewhere for part of the year.
Even if you go on extended vacations for part of the year, as long as you own only one property there aren’t stipulations as to how much time you spend at the primary residence for it to count as one.
Why primary residence definition matters
Understanding the definition of primary residence is important because it affects your mortgage rates, tax deductions, and exclusions on capital gains taxes.
Mortgage rates for second home vs. primary residence
When it comes to applying for financing, the home you want to buy can have a significant impact on the rate you’ll qualify for. In most cases, mortgage rates for a primary residence tend to be lower.
The reason mortgage rates for a second home vs. a primary residence are higher is because lenders tend to view the purchase of additional properties as riskier. If you take on an additional mortgage for a second property, you’ll need to prove you have the financial means to repay that loan, as well as your primary home’s mortgage.
Considering lower rates can mean thousands of dollars (if not more) in savings over the lifetime of your mortgage, it’s important when comparing mortgage lenders to let them know what type of property you’re buying to ensure you get the correct rate offers. Use a mortgage calculator to estimate your monthly payments.
Mortgage interest tax deduction for primary residence
You may be able to deduct the mortgage interest you paid on your primary residence for tax purposes if you itemize your deductions. If so, you can deduct up to $375,000 for single and married filing jointly filers, or up to $750,000 for those married filing jointly for mortgage interest paid in 2018 and beyond.
Capital gains on primary residence
Another tax benefit of owning a primary residence is the potential to benefit from the capital gains exclusion.
When you sell certain assets that have increased in value, you’ve earned capital gains and could be subject to capital gains tax by the IRS. Yes, that means when you sell your home for a profit, you’ve earned capital gains.
However, if you sell a primary residence that has increased in value, you can exclude some of the capital gains earned. The IRS currently allows you to exclude up to $250,000 in capital gains if you’re single, and up to $500,000 if you’re married and filing taxes jointly.
For instance, say you and your spouse bought a home for $250,000 six years ago and it’s the only home you own. You both decide to sell the home and move to retire in another state. After having a real estate agent assess your property, you learn its current market value is $400,000. After selling the home, you’ll make a profit of $100,000, after closing costs.
If you’re able to meet the IRS criteria for an exclusion, you won’t pay capital gains tax on the $100,000 you netted.
Here’s what you need to do to qualify for the capital gains tax exclusion:
- Owned the property for a minimum of 24 months within the past five years.
- The property needs to have been your primary residence for a minimum of 24 months from the past five years
- In the past two years, you haven’t claimed another capital gains tax exclusion
There is an additional requirement to keep in mind: purchasing the property through a 1031, or like-kind exchange. If you previously owned a rental property and decided to sell it to purchase another one, you can do a 1031 exchange.
A 1031 exchange allows you to defer paying capital gains tax on the sale if it’s completed during a specific timeframe since the property will be used for a similar purpose — or like-kind.
However, if you decide to move into your investment property and convert that into your primary residence, then you won’t qualify for the capital gains tax exclusion if you sell the home within five years.
Since these types of transactions can be complex, consider seeking the advice of a tax professional to determine what your specific tax obligations are.
How do you prove you live in your primary residence?
Here are a few ways you can prove you live in your primary residence:
- Show you don’t own any other property or homes.
- List the address of your primary residence when filing your tax returns.
- Use the address on your driver’s license.
- Register to vote using the primary residence address.
- Have bills such as utilities or credit card statements mailed directly to your primary residence.
- Write a letter of explanation or provide some other proof that your primary residence is within a reasonable commuting distance from your work.
Need more guidance to buy a primary residence? Contact a local Finance of America Mortgage Advisor today to get started.