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Selling your second home? When you sell a vacation home, rental, fix-and-flip, or any second property that is not your primary residence, you will typically be responsible for paying capital gains taxes on any profits you make, at a rate of up to 20%, depending on your tax bracket. But you may be able to mitigate those taxes. In this article, we discuss under what conditions you can minimize your capital gains tax, and maximize your profits as sellers.
To give you the most up-to-date information, we talked with real estate attorney Koert Brown with Rammelkamp Bradney in Illinois, and top real estate agent AJ Pettersen of the Advisor Realty Group, a high performance real estate team in Minneapolis that also specializes in Townhome sales.
Disclaimer: Information in this blog post is meant to be informational and used as a helpful guide only, and not professional tax or legal advice. If you need help determining the taxes on the sale of your second home, HomeLight always encourages you to reach out to a tax advisor regarding your particular situation.
Selling a second home vs. selling a primary residence
When selling a primary home, the seller generally doesn’t have to worry about paying taxes on profits — up to a certain point. The IRS allows a single-filer homeowner to forgo paying taxes on up to $250,000 gained from the sale, and a married couple can exclude up to $500,000 in profit.
Brown says a property is considered a primary residence if the owners occupy it the greater part of a year (6+ months) for at least two of the past five years, and can prove it. For audit purposes, proof is determined by where the owner is employed, banks, receives mail, and attends community places like recreational clubs.
You typically have to pay tax on capital gains on sale of a second home at a rate of up to 20% in 2022, depending on your tax bracket.
A property is considered your second home if it’s a vacation home or an investment property that you rent out.
How much you’ll pay in capital gains tax depends on several factors:
- How long you’ve owned the second home
- The cost of owning the property, including the cost of capital improvements and any fees
- Your income tax bracket
- Your marital status
- Whether you rent out your second home
- Whether you replace that property with a like-exchange
- Whether you claim an investment loss in the same tax year
What are capital gains taxes?
Capital gains taxes are the taxes you pay when you sell an appreciating asset and make a profit (capital gain). According to the IRS, there are two main categories of capital gains tax on the sale of a non-primary residence:
- Short-term capital gains tax. This is a tax on any profits from the sale of a property that you’ve owned for one year or less. For short-term properties, you’ll typically pay the same tax rate as you would for your ordinary income.
- Long-term capital gains tax. If you’ve owned your second home for more than a year, you’ll typically pay a long-term capital gains tax between 0% and 20%, depending on your earnings. According to the IRS, property owners will pay a 15% tax unless they exceed the higher income level.
What’s the 2022 capital gains tax rate?
For tax year 2022, a capital gain rate of 15% applies if your taxable income is $40,400-$445,850 for single, $80,800-$501,600 for married filing jointly or qualifying widow(er), $40,400-$250,800 for married filing separately, or $54,100-$473,750 for head of household.
In 2022, a net capital gain tax rate of 20% applies if your taxable income exceeds the thresholds set for the 15% capital gain rate.
Ways to reduce your capital gains tax
The capital gains tax may seem high, but don’t kiss all of those tax dollars away just yet. Depending on your situation, there are several different ways that you may be able to mitigate some of your capital gains.
Adjust your profits to reflect any acquisition costs or property improvements
At the most basic level, your capital gain is calculated by figuring out your cost basis and subtracting any profit made from the sale.
The cost basis is typically the amount you spent to buy and improve your second home, including the purchase price, any acquisition or closing fees, and the cost of any capital improvements you made while owning it. Capital improvements are permanent repairs or upgrades not including routine repairs or maintenance. For a list of the capital improvements you can add to the cost basis of your home, see IRS Publication 530.
You can also increase your cost basis by adding any qualifying real estate fees, such as real estate commission and closing costs, paid when selling your second home, which can reduce your taxable gain even further.
How to calculate capital gains tax
Remember that the capital gains tax depends on marital status, how long you’ve owned your home, your taxable income, and your net profit. For example, if you’re married filing jointly with a net combined income of $233,000, and you purchased your second home for $400,000 and sold it for $500,000, it would initially appear that you profited $100,000 from the sale.
But if you also spent $15,000 on acquisition costs, $20,000 to renovate the bathrooms, $25,000 to put on a new roof, and $30,000 in real estate commission, your cost basis may be $490,000. Your profit could actually only be $10,000. In this example scenario, you’ll pay a capital gains tax rate of 15% or $1,500.
Depreciate the property if it was used as a rental
If you rent out your home, you can typically deduct depreciation on an annual basis. Simply put, depreciation is the tax deduction of the cost to fix, update, maintain, or own a rental property, spread out over the years you own the property.
If your second home was rented out while you owned it, you could opt to deduct real estate depreciation for the number of days it was occupied by renters or available to rent each year. As an example, if the property was rented or available to be rented for half of the year, you could claim 50% of the yearly depreciation deduction. Each year, the depreciation would continue to reduce your cost basis.
However, keep in mind that if you depreciate your second home, you’ll have to pay another tax called a depreciation recapture, which is a flat 25% of the cumulative depreciation. For example, if you’ve claimed $35,000 in total depreciation, you would likely face an additional $8,750 in taxes when you sell.
Rent out your second home
You cannot depreciate a vacation home, which is considered personal property, but because it’s a second property, when you sell, it is fully taxable at the capital gains rate as an investment. However, renting out a vacation home is one of the most common ways for a homeowner to mitigate their tax liability on the sale of a second home. In this case, you can typically deduct depreciation and the costs to own, maintain, and rent that property.
To use this strategy, you’ll need to start renting out the home long before you list it. It’s also important to note that if you use this strategy to mitigate your capital gains tax, you cannot have used it as a primary residence the last two of the past five years, and you will very likely have to pay the depreciation recapture tax. It’s strongly encouraged that you consult with a tax and/or real estate professional to map out whether this strategy is available and how it might apply to your situation.
Make your second home your primary residence
Another way to reduce your tax liability is to turn your second home into your primary residence, which will make you eligible for up to $500,000 exclusion. Every homeowner will most likely exempt the sale of a primary residence within their lifetime, says Brown.
The definition of primary residence is most important when going about making your second home your primary residence. You must have lived in it the majority of the year (6+ months) in any given year for two out of the last five years.
“That’s the safe harbor that will get you there. The tests, facts, and circumstances that prove a home is your primary residence include your place of employment, where you have your mail sent, where you bank and where you go to church,” says Brown.
It’s important to note that you can’t use this strategy if you have excluded a capital gains tax on the sale of another property within the past two years.
Do a 1031 exchange and defer capital gains tax
Named for the IRS Code Section 1031, a “1031 exchange” — also called a “like-kind exchange” — allows you to swap out an investment home for another property of the same type without paying any capital gains tax.
The 1031 exchange can generally only be used if the real estate involved is an investment or business property, so you can likely only employ the like-kind strategy if your second home is used primarily as a rental rather than for personal enjoyment, and the replacement property cannot be used as your primary residence. There are also other specific exclusions in the tax code even if a property is used for investment or business purposes. These include:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
If you want to do a like-kind exchange, the clock starts ticking right after you sell the first property. You must find the replacement home within 45 days and must close on the second purchase within 180 days. If you miss that deadline, you’ll get hit with the full capital gains tax.
With the 1031 exchange, you do not avoid capital gains tax altogether. Instead, you are deferring the tax until you sell the replacement property. However, there is typically no limit to the number of times you can defer the capital tax with the 1031 exchange. You can continue rolling capital gains into a replacement investment property indefinitely, deferring the tax over and over and eventually paying it or passing the rental property to a beneficiary.
Property requirements for the 1031 exchange
So you’d like to take advantage of the 1031 exchange rule — but how do you know if your property and the replacement property qualify?
For the initial property, these conditions apply:
- You must have owned and held the property for at least 24 months immediately preceding the 1031 exchange; and
- You must have rented the subject property at fair market rates to other people for at least 14 days (or more) during each of the preceding two years; and
- You must have limited your personal use and enjoyment of the property to not more than 14 days during each of the preceding two years, or 10% of the number of days that the property was actually rented out to other people during each of the preceding two years. For example, if you rent your investment property for 330 days in a given year, you can use it for personal enjoyment no more than 33 of the remaining 35 days of that year. However, time spent in the home to do maintenance and repairs don’t count toward that limit.
For example, if you rent out your vacation home at least 14 days per year for two consecutive years, don’t live in it more than 14 days per year, and it’s considered an investment property in the eyes of the IRS, it could be eligible for the 1031 exchange.
Likewise, the replacement property must meet the following criteria:
- You must own the property for at least two years after exercising the 1031 exchange; and
- You must rent it out for at least 14 days per year; and
- You cannot use the property for personal enjoyment for more than 14 days per year or 10% of the days the home is rented out.
According to Petersen, the biggest difficulty with 1031 exchanges right now is the deadline combined with the inventory shortage. “It’s not easy to find a like-kind property for a 1031 exchange in the first place and it can be harder still to do it in a 45-day time frame. I’ve had 1031 exchanges fall through because of the housing shortage.”
A warning about deferred 1031 exchanges
For homeowners wanting more flexibility in the 1031 exchange timeline, there is such a thing as a deferred exchange in which the owner sells the property to a qualified intermediary, known as a 1031 Accommodator, who buys the property at a later date. The entire process must still take place within 180 days and the sale is more complex as well as more risky.
The IRS warns that homeowners should fully vet a 1031 Accommodator and beware of schemes as there have been instances of these sales falling through or not meeting IRS requirements. It’s important to consult with a tax and/or real estate professional to see if this strategy might work for you.
Offset capital gain from sale of rental property with an investment loss
If your second home is a rental property and you are holding an investment that has lost value, there is a tax provision that may let you sell that investment in the same tax year to offset some or all of your capital gains. Also called tax-loss harvesting or tax-loss selling, this investment strategy is commonly used to minimize taxable capital gains from investment income, but can sometimes also be used to offset capital gains from the sale of a rental property.
When using this strategy, Brown says it’s important to remember that a short-term capital gain can only be offset with a short-term capital loss; a long-term capital gain can only be offset by a long-term capital loss.
Example: In July 2021, Jim and Elizabeth sold a rental property for a net profit of $45,000. They were holding a stock investment that had lost $55,000 in value. To offset their capital gains for tax year 2021, they sold $45,000 of that stock at the end of 2021 and paid $0 capital gains tax.
When in doubt, talk to a professional
Real estate taxes can get complicated fast. It’s best to partner with a real estate accountant and a top real estate agent with experience in selling second homes. They can help you determine your net profits and identify opportunities to mitigate your capital gains tax so you don’t pay more than you absolutely must.
Header Image Source: (Gunnar Ridderström / Unsplash)
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- "Publication 523 (2021), Selling Your Home," Internal Revenue Service (January 2022)
- "Understanding Depreciation Recapture When You Sell a Rental Property," Million Acres (February 2021)
- "Like-Kind Exchanges - Real Estate Tax Tips," Internal Revenue Service (January 2022)
- "Tax-Loss Harvesting," Investopedia (March 2022)