In the previous two articles, we discussed how to qualify for a mortgage on investment properties and loan-to-value (LTV) requirements for investment property. In this article, we discuss the 3 main differences between buying an investment property and buying an owner occupied property. When buying an investment property, make sure you understand the limitations on seller’s concessions, reserves, and make the most of your profit when you sell by doing a 1031 exchange.
Difference #1: Seller’s Concessions Are More Limited
What is a seller’s concession?
Let’s say you are buying a house. You negotiate the purchase price with the seller but during negotiations, you tell the seller you need help with the closing costs. You and the seller agree to a sales price for the house of $400,000 with a 6% seller’s concession. This means that at closing, the seller will contribute $24,000 toward your closing costs. However, the seller’s concession can only go toward your actual closing costs. You can’t get cash back from any unused or excess seller’s concession. For more details, read our post on seller’s concessions.
How much of a seller’s concession can you get?
If you are buying a primary residence, the amount of the seller’s concession is based on your loan-to-value. If your LTV is between 75.02 and 90.00%, the maximum seller’s concession is 6%. If your LTV is between 90.01-97.00%, the maximum seller’s concession is 3%. And if your LTV is 75% or less, you can get up to 9% of the sales price as a seller’s concession.
Now if you’re buying an investment property, the maximum seller’s concession is limited to 2% of the sales price, regardless of LTV! That’s right — you could be putting down 25% and you can still only get 2% of the sales price toward your closing costs.
Are there any limits on buying a house with a seller’s concession?
Yes. The property has to appraise for the purchase price (or higher). What does that mean? Sometimes, people will see a house that’s listed for a certain price and they tell the seller they will agree to pay more than the asking price so the seller can give a seller’s concession and still walk away with the same amount of money in his pocket.
For example, let’s say, a house is listed for $400,000. If the seller sold it for $400,000 with no seller concession, he would get $400,000 (before realtor commission). But if the seller knew he had to give the buyer a seller’s concession in order to make the deal happen, and the seller wanted to walk away with $400,000, he and the buyer would agree to a higher price of let’s say $412,500 so he could give the buyer a 3% seller’s concession (or $12,375) and still walk away with $400,000. However, when the bank appraiser goes out to appraise the house, and if it doesn’t appraise for $412,500, the bank will only lend off the lower of purchase price or appraised value. So if you’re going to buy a house with a seller’s concession, you should be fairly certain it will appraise for the price you agreed to.
Difference #2: Reserves Are Higher
What are reserves?
Every lender wants to make sure you don’t use up every penny of your checking and savings accounts to buy the house because what if something breaks or you lose your job? How are you going to make your mortgage payments or fix the hot water heater?
How much do you need to have in reserves for primary residence?
It depends on loan-to-value and occupancy. If you are buying a primary residence, you may only need 1-2 months of reserves. 1-2 months of what? Your total mortgage payment (PITI) — principal, interest, tax, insurance, and PMI, if applicable. Read our detailed post on assets and reserves requirements for various types of mortgage loans.
How much do you need in reserves for an investment property?
If a borrower is financing an investment property, and if they own a second home or other investment properties, they will need reserves based on the unpaid principal balance of all mortgages. If this is the only investment property they are buying, it’s up to the underwriter, but often a borrower is required to have at least six months of mortgage payments in the bank after they close.
Difference #3: 1031 Exchange
What is a 1031 exchange?
Let’s first step back and talk about the tax treatment when you sell an investment property compared to selling a primary residence. If you bought your primary residence five years ago for $600,000 and now you’re able to sell it for $800,000, you don’t have to pay tax on your $200,000 gain because you probably qualify for the capital gains exclusion for primary residences.
But what if you’re selling an investment property that appreciated in value over the years? Can you avoid paying capital gains tax then?
Yes, if you do what’s called a “1031 Exchange” or “like kind exchange”. Simply put, with a 1031 exchange, you take the proceeds from your sale of investment property and put that money with a qualified intermediary who holds on to it for you. Then, when you are ready to buy another investment property, you can roll the proceeds from the sale into the new purchase and you have now avoided paying capital gains tax on the increase in value. There are certain restrictions the IRS imposes to be able to do a 1031 exchange (such as minimum holding period of at least a year for the new purchase before you sell; you must roll the proceeds over into a “like” property, so if you’re selling an investment property, you must use the proceeds to buy another investment property).
Do banks let you use money from a 1031 exchange?
Yes! You just need to document the sale with your closing statement and get verification from the intermediary that they are holding the proceeds for you.