Guide to Primary Residence Mortgage: Tax Advantages and Benefits

Mortgage Dove

Guide to Primary Residence Mortgage: Tax Advantages and Benefits

Your primary residence, often referred to as your principal residence, holds the key to various financial benefits, including potential tax advantages. 

Whether it's a house, condo, or townhome, understanding the definition of your primary residence is crucial for navigating tax seasons and maximizing its value. From lower mortgage rates to deductions on mortgage interest and the exclusion of capital gains tax, your primary residence can significantly impact your financial well-being. 

This guide will explore the rules surrounding primary residences, capital gains exclusions, and how these aspects differentiate primary from secondary residences. Understanding these intricacies is essential for homeowners seeking to optimize their financial benefits and make informed property decisions.


What is a Primary Residence?

Your primary residence, also called your principal residence, is where you live most of the time. It could be a house, apartment, or townhome. It becomes your primary residence if you can show that you live there for most of the year. Classifying your home as a primary residence might mean you can get a lower mortgage rate.

Having a primary residence can also give you tax benefits. It includes deductions on the interest you pay for your mortgage and not having to pay taxes on the money you make when you sell your home. The IRS has some clear rules to help people understand if their home can be a primary residence. These rules help determine if your home qualifies as your primary residence.

Principal Place of Residence
"Primary residence" is another way to say "principal place of residence." Both phrases talk about the primary or main home where you stay most of the year. But the exact meaning can change based on where you are and the usage of the words. For instance, sometimes, "principal place of residence" might mean a person's permanent address.


Rules About Primary Residences

Owning a primary residence comes with specific rules set by both mortgage lenders and the IRS to qualify for certain benefits. Some essential rules include:

  • Occupancy Duration: You must occupy your primary residence for most of the year. It is usually referred to as residing in the home for more than half the calendar year.
  • Post-Closing Occupancy: Many lenders require you to move into your primary residence within a specific period after closing, often around 60 days.
  • Duration of Residence: You must usually live in the home as your primary residence for at least one year after closing.
  • Location of Employment: Your primary residence should be conveniently located near your place of employment unless your employer validates that you work remotely.
  • Restrictions on Conversion: If you plan to convert your home into a rental or investment property within six months of closing, it might be classified as an investment property, potentially impacting your mortgage terms.


Moreover, if you're trying to get a loan to buy a home, often the people giving you the loan will want to make sure that the house you're buying is the one you plan to live in most of the time. It is especially true if you're applying for a loan specifically for your primary residence, like a mortgage loan meant to help you pay for the house you plan to live in most of the time.


Primary Residence Benefits

The advantages of buying and using a home as your primary residence are numerous:

  • Lower Interest Rates: Primary mortgage loans typically come with lower interest rates and more favorable terms than mortgages for non-owner-occupied properties.
  • Mortgage Interest Deduction: Primary homeowners may be eligible for a mortgage interest deduction on their federal income taxes, leading to substantial tax savings.
  • Property Tax Benefits: Property taxes on a primary residence are often lower than those on investment or rental properties, providing additional financial relief.
  • Long-Term Investment: Owning a primary residence can be a lucrative long-term investment as home prices tend to appreciate over time.


The "2-out-of-5-Years Rule"

One notable benefit of owning and living in your primary residence is the "2-out-of-5-years rule." According to this IRS rule, if you sell a home that has been your primary residence for at least two of the five years immediately preceding the sale, you may be exempt from paying capital gains tax, depending on the profit made.


Capital Gains on a Primary Residence

Owning a primary residence offers more than just a tax break on mortgage interest; it also opens the door to excluding capital gains when you decide to sell. Capital gains tax applies when selling an asset that has appreciated. When selling your primary residence, you may qualify to exclude a portion of the capital gains from the sale proceeds.


As of currently IRS regulations, married couples filing jointly can exclude up to $500,000 in capital gains. On the other hand, single individuals can exclude up to $250,000. For example, say you bought your primary residence for $200,000, and it's your only home. After residing there for a few years, you decide to sell it for a profit of $50,000. If you meet the exclusion criteria, you can avoid paying capital gains taxes on this profit. The capital gains tax rate varies between 0%, 15%, or 20%, depending on your income.


To qualify for the exclusion, you must meet the following criteria:

  • Ownership Duration: You must have owned your home for at least 24 months out of the previous 5 years.
  • Residence Duration: The property must have been your primary residence for at least 24 months out of the previous 5 years.
  • No Previous Exclusion: You cannot have claimed another capital gains exclusion in the past 2 years.


By meeting these conditions, you can maximize the benefits of excluding capital gains on the sale of your primary residence, contributing to potentially significant savings during tax season.


The 1031 Exchange

While capital gains exclusions are generally available for primary residences, there's an exception for properties acquired through a 1031 exchange. Suppose you obtained an investment property through a like-kind exchange and later converted it into your primary residence. In that case, it may not be eligible for the capital gains exclusion if sold within five years of purchase.


Primary vs. Secondary Residence

Recognizing the distinction between a primary residence and a secondary property, such as a second home or vacation house, is essential. Unlike primary residences, secondary residences are typically occupied for only a portion of the year.


However, suppose you have a mortgage on a secondary property and intend to rent it out. In that case, you might be required to reside in it for at least a portion of the year. It is particularly pertinent if your mortgage is backed by entities like Freddie Mac or Fannie Mae, stipulating that the leased property should be "available primarily for the borrower’s personal use and enjoyment" for more than half of the calendar year.


Several other rules come into play. According to the IRS, you can rent a second home for up to 14 days and keep the profits tax-free. Exceeding this duration necessitates reporting the rental income. Additionally, if you eventually sell the second home at a profit, you may be liable for capital gains taxes. Understanding these distinctions is crucial for homeowners navigating the complexities of primary and secondary property regulations.


The Bottom Line

It's wise to know what kind of home you're getting if you're considering buying one. Will it be your primary residence, a secondary residence, or a property you plan to invest in?


These choices matter because they can impact the interest rate on your mortgage and how your mortgage payments are treated for taxes. It also counts when you sell the house and make a profit. Understanding which home is your primary residence is crucial, whether you're buying a new place or refinancing your current mortgage.

"Mortgage Dove makes home financing convenient for every American. You can count on us to provide a home buying experience tailored to your personal needs and financial situation. We strive to give you the peace of mind that your home financing goals can be achieved.”


Other Related Articles you may be interested in