How to Convert a Second Home to an Investment Property

More homeowners than ever are converting their primary residences into investment properties, opting to hold onto the homes and rent them out instead of selling them when they move out. Some people believe they can earn extra money each month with these rentals, while others don’t want to sell the property and lose out on favorable mortgage terms. 

While each homeowner has different experiences, three main scenarios are driving these conversions: accidental landlords (people forced to move because of job relocation), strategic investors (homeowners looking to maximize portfolio returns), and life transitions (retiring or downsizing homeowners).

If you fall into one of these categories, make sure you think your home conversion through. Managing a rental property requires careful planning and professional guidance to avoid costly mistakes.

Here’s how to convert a second home to an investment property and common pitfalls to avoid.

Legal Difference Between Second Homes and Investment Properties

The first thing to know is that the Internal Revenue Service (IRS) and mortgage company both care that you are turning a second home into an investment property. A second home is a vacation home or a property that you use when you aren’t in your primary residence. 

According to the IRS, a house is considered an investment property if its usage drops below 14 days or 10% of rental days. (If you rent your house out for 300 days per year, then you would need to stay in it for at least 31 days.) There is also the 15-day rule, which states homeowners who rent their property for less than 15 days throughout the year don’t have to report the income on their taxes. However, they also can’t deduct any rental expenses either.  

Lenders also need to know about any conversions of a primary or secondary home. Many companies consider a failure to notify a form of mortgage fraud, as owners are intentionally deceiving them about how the property is used.  

Second home mortgages typically have occupancy clauses requiring the property to remain a personal residence. Investment properties also typically have higher interest rates, which means lenders lose out when owners fail to notify them of the change.

You will need to contact your lender about the change and potentially refinance your home loan to convert the house to an investment property. This is often the first mistake homeowners make – they don’t factor in the changes in monthly payments that come with refinancing. The rental income might not cover the new mortgage costs.  

Financial Requirements and Considerations

Before you can start marketing your property and looking for tenants, you need to make sure that managing a rental property makes financial sense.

Your house will only generate rental income based on local rates, and that might not be enough to cover all of your costs. Here are a few financial aspects to consider. 

Refinancing Requirements

Review your finances to confirm you can afford to buy an investment property and receive a loan from a mortgage company. While you can buy a primary residence with a 3% down payment (if you use an FHA loan), most mortgage companies want at least 20% down for an investment loan. They also expect lenders to have credit scores in the high 600s or 700s. 

Interest rates for rental properties are 0.5-0.75% higher than primary homes on average, and many lenders require six-month reserve requirements. Your lender will also calculate your debt-to-income ratio (DTI) for your investment mortgage loan, using the same calculation as a primary residence.  

Some buyers might be able to apply for a Debt Service Coverage Ratio (DSCR) loan, which takes the potential rental income into account. The lender will confirm that the buyer can use enough rental income to cover the monthly payments of the loan. 

Insurance Conversion

Homeowners will also need to call their insurance companies to let them know that they are transitioning the house to a rental property. This often leads to insurance premium increases. Landlord insurance is 25% higher on average than standard home insurance.

These premiums cover dwelling protection and increased liability coverage. Some homeowners add special coverage to the premiums to cover loss of rental income if the property becomes uninhabitable. 

Shop around for different coverage options as you go through this process. This will ensure you are protected while helping you save money.

Cash Flow Analysis

Consider all of the potential costs of owning an investment property and how they stack up against your monthly rent. These include: 

• Monthly mortgage payments
• Insurance premiums
• Property taxes (which may increase without a homestead exemption)
• Homeowners’ association (HOA) fees
• Utilities during vacancies
• Marketing costs
• Property manager fees (8-12% of the rental fee on average)
• Maintenance (at least one month’s rent annually)  

It is better to plan for extra costs so you can budget for them. For example, if your house is vacant for two months out of the year, you lose out on two months of income. If the laundry units break in your home, you could lose out on another month’s worth of income replacing them. Home repairs don’t stop when someone starts renting your property.

Tax Implications of Converting to Rental Property

You also might want to consult a tax professional before you convert your home into a rental property. There are several tax implications to making this change, for better or worse. While you can enjoy some tax benefits, there are a few drawbacks you might not be aware of. 

• Owners of investment properties can deduct the depreciation of the assets over time. The IRS spreads this deduction across the property’s useful life. 
• Homeowners can deduct expenses like mortgage interest, property taxes, insurance, repairs, maintenance costs, property management, advertising, and travel to manage the property. This can lower your tax burden. You can deduct mortgage interest annually until you pay off your loan.
• Homeowners will no longer qualify for the capital gains tax exemption and will have to pay this tax when they sell the house. The tax is based on the profit from the home sale, or the sale price minus the purchase price. There are also several deductions included in capital gains calculations.  

Document each change you make to the house and how to report it on your taxes. For example, the IRS differentiates between repairs, which are deductible, versus improvements that must be depreciated. Replacing a broken dishwasher would be a repair, while upgrading the kitchen countertops is an improvement.

Tax laws and benefits change frequently, so talk to a real estate tax professional for guidance before transitioning your home. They might recommend making the switch sooner so you can take advantage of tax benefits while they last.

State-Specific Regulations and Compliance

Another benefit of speaking with an expert before turning a vacation home into an investment property is that you can learn about specific state requirements that aren’t common in other parts of the country. These can include added fees you weren’t ready for or extra housing requirements to stay compliant with local laws. Here are a few examples of state-specific regulations. 

• California: There are specific wildfire compliance requirements, rent control implications, and stricter tenant protections than in other parts of the country. 
• Florida: There are SB280 occupancy limits, state registration requirements, and no income tax benefits. Some Florida homes may need extra insurance because of flooding and hurricanes. 
• Texas: There are also no income tax advantages in this state, strong property rights, and homestead exemption loss. 
• New York: There are sales taxes on short-term rental properties, strict regulations in New York City and the surrounding boroughs, and a high tax burden.

Most states and municipalities have regulations for rental registration requirements, business licenses, safety inspections, and HOA restriction verification. Check local laws for rental properties and consider the zoning ordinances for short-term rental allowances. The laws for long-term and short-term rentals often differ, so consider how you want to use your vacation home.

Step-by-Step Conversion Process

Follow these steps if you are ready to generate income through a secondary residence. You can make sound decisions whether you are converting an existing property or actively buying a second home. 

1. Market Analysis and Rental Viability

Work with a real estate agent from FastExpert or browse local multiple listing service (MLS) data to understand the rental market where you live. This will tell you the average rental rate for similarly-sized homes in your area. If you charge too much, you might not get any rental applications, and your home could stay vacant for longer than you expect. 

This is also a good time to decide whether you want to opt for a long-term or a short-term rental. Some areas ban short-term rentals or have strict laws to regulate them. While they are desirable for collecting rent, they take more work. Long-term rentals are more stable (you can require a six-month or one-year lease), but it may take longer to find and vet tenants.

Also, consider how market demand will fluctuate in your area. A short-term rental in a vacation destination might have busy months and slow periods. Changes in the local workforce or employment can also change rental demand.

2. Legal and Financial Preparation

Review your mortgage documents for occupancy requirements and see if there are any clauses or sections related to converting the property. You can also contact your lender directly about the conversion process. They may require you to refinance the home loan, which can be a time-consuming and expensive process. If you need to refinance, shop around for rates. You might be able to save money by doing so. 

During this time, handle other financial aspects of the home. Shop around for insurance quotes and discuss what the conversion means for tax purposes with a financial expert. You should also review your HOA documents for rental restrictions and start the process of letting your association know what changes they can expect from the property.

3. Property Preparation

Once your finances are in order, you can take steps to prepare the property for renters. You may want to schedule a professional inspection to identify needed repairs that could prevent you from staying compliant as a landlord. You have an obligation to your tenants to provide a safe property in good condition, and that starts with pre-emptive repairs. 

Address safety requirements during this time (like installing smoke detectors, carbon monoxide detectors, and egress windows) and consider any other improvements you want to add. For example, you may decide to install safety bars in the shower for guests to hold on to. 

This is also when you will decide whether you plan to rent the property with or without furniture. It’s more common to furnish the property for short-term rentals, so you will either leave your items in place or invest in furniture designed for your space and renters. If you are renting the property without furniture, you will move out and sell your items or put them in storage. 

The final step in this process is to document the property with photos and videos. This provides an up-to-date overview of the condition of the home. If something happens, this content will be useful for filing insurance claims.

4. Administrative Setup

Next, start working with your local municipality to handle the administrative requirements of second home ownership. Obtain the required licenses and permits to transition your investment property and familiarize yourself with any local laws. 

You will also want to set up separate bank accounts for your rental income and expenses. This will make it much easier to keep track of the money coming in and leaving your account, which determines how profitable your rental property is. Establish a bookkeeping system for tax purposes so you can easily report your expenses and earnings. There are plenty of free bookkeeping tools online that you can try out to discover what works best for you. 

During this time, complete other administrative tasks like creating lease agreements and tenant screening procedures. While you can find templates online, you will want a local attorney to review these documents to make sure they are legal and fully protect you and your assets.

5. Marketing and Management Decisions

Finally, you are ready to market your home and review applications. Decide between self-management and professional management for your property. While professional management costs more, it can take a lot of time and stress off your plate. Set competitive rental rates based on your recent market analysis and promote your home with a compelling listing that has professional photos.

During this time, establish maintenance and emergency response procedures. These include processes for tenants to request repairs when something breaks and how you provide notice to them about accessing the home. Emergency response procedures can cover house issues (like a burst pipe) or regional problems, like impending storm prep. Discussing these cases beforehand can prevent you from panicking when a crisis arises. You will already have steps in place to protect your home.

Common Rental Income Pitfalls to Avoid

Making mistakes is a natural part of life, and you will likely face several unexpected challenges during your first year managing a rental property. However, there are a few common real estate pitfalls you can avoid. Here are a few ways to make sure the process of turning your vacation home into an investment opportunity goes smoothly. 

• Failing to notify mortgage lenders: Be prepared to refinance if necessary and ensure you can meet their down payment requirements.  
• Underestimating renovation and maintenance costs: Follow the 3% rule to save for repairs. Allocate at least 3% of the home’s value to repairs each year.
• Forgetting tax obligations: Talk with a tax expert before you convert your vacation property. 
• Having inadequate insurance coverage: Shop around for rates to make sure you have the coverage you need. 
• Ignoring local regulations: You could rack up costly penalties if you’re not careful. 
• Mixing personal use with rental activity: Make sure you strike a healthy balance so the property qualifies for the right tax perks. 
• Poor tenant screening: This could lead to costly evictions, unexpected repairs, and more vacancy time where you lose valuable income. 
• Emotional attachment: Letting emotions get in the way of property management can prevent sound business decisions. 

Many first-time landlords prefer to work with a real estate agent or property manager to get the help they need. They let the house generate passive income while still taking the necessary steps to protect themselves.

Converting a Primary Residence Can Be a Good Investment 

Converting a second home to an investment property can provide excellent returns when done correctly. However, success requires careful planning, compliance with legal requirements, and often professional guidance. The decision should align with long-term financial goals and lifestyle considerations. 

Consider the current mortgage rates, expected costs, and your own personal finance situation before buying a second home or converting an existing one. Make sure you factor in all potential costs and benefits of this action. All investing involves risk, but the good thing about real estate is that you can factor in most of the potential drawbacks and opportunities. 

Turn to FastExpert’s local real estate professionals if you are looking for a local market analysis and rental information. You can also connect with qualified service providers, like lawyers and tax experts, who can guide you through the conversion process. They can help you reach your financial goals while also making the most of your second property.