Capital Gains and Tax Consequences of Selling a Second Home

A second property (even if lived in by the owner for several months of the year and not a rental property) is considered an investment property in the eyes of the IRS. Therefore, the capital gains tax exclusion does not apply to second or vacation homes. All sales profits are subject to capital gains tax, which can be new to many owners when it’s time for them to sell.

If you sell a house for a profit, you benefit from capital gains. If you’re selling your primary residence, up to $500,000 of your gains are tax-exempt. But what are the tax consequences of selling a second home?

This article explains how capital gains tax is applied to a second property and provides practical strategies for minimizing tax obligations.

What Are Capital Gains Taxes?

If you sell an investment, such as stocks, bonds, real estate, or valuable personal property for a profit, capital gains tax is the tax applied to the profits from those investments.

The amount of capital gains tax you pay depends on several factors, including how long you held the asset, your income level, and your filing status.

Short-Term Capital Gains Tax

Investments held for less than a year get taxed with short-term capital gains. The federal tax rate of short-term capital gains is taxed at ordinary income tax rates, and some states have an additional capital gains tax.

For example, California residents can pay up to an additional 13.3% in capital gains taxes. This can be an important distinction for real estate investors who buy and flip homes, as they often pay taxes at their ordinary income tax bracket instead of long-term capital gains, resulting in a larger tax bill.

The table below outlines the ordinary income tax brackets for 2024.

Long-Term Capital Gains Tax

Long-term capital gains rates apply to investments held for over one year. The tax rate for long-term gains is considerably lower than short-term capital gains tax.

Most owners selling a second home will qualify for long-term capital gains, meaning they won’t have to pay taxes on the profit at their ordinary income tax bracket rate.

The table below outlines the Federal capital gains tax brackets for 2024.

When selling a second home, it is preferential to pay at a long-term capital gains tax rate rather than the short-term capital gains rate. A homeowner selling a second home with a $150,000 profit could have a tax bill over $52,000 if short-term capital gains are applied (assuming their normal salary is $80,000).

However, if they own the property for over a year and their profit is taxed as long-term capital gains, the tax on the profit is only about $27,000.

Capital Gains Tax Exclusion in Real Estate

While a second home or investment property follows traditional capital gains tax rules, if you are selling your primary residence, you qualify for a capital gains tax exclusion. This exclusion is part of Internal Revenue Code Section 121 and is designed to help homeowners avoid paying taxes on the profit from the sale of their homes under certain conditions.

If you are single and meet the eligibility requirements, you can exclude up to $250,000 of the capital gain from the sale of your home. If married and both spouses meet the eligibility requirements, they can exclude up to $500,000 of the capital gain.

To qualify for the exclusion, you must have owned and lived in the home for at least two of the last five years before the sale. This is known as the “ownership and use test.” The time spent living in the home does not need to be consecutive.

The exclusion can be claimed only once every two years. If you don’t meet the ownership and use tests, you may still qualify for a partial exclusion under certain circumstances, such as a change in employment, health issues, or unforeseen circumstances.

Tax Implications of Selling a Second Home

Unlike a primary residence, you cannot exclude any capital gains from the sale of a second home. All profits are subject to capital gains tax. If you’ve held the property for more than one year, it will be taxed at the long-term capital gains rate.

If you’ve held the property for one year or less, it will be taxed at the short-term capital gains rate, which is equivalent to your ordinary income tax rate.

The gain is calculated as the difference between the selling price and the property’s adjusted cost basis.

An adjusted cost basis takes into account:

• Purchase Price: The amount paid to buy the property, including cash, mortgage, or other forms of payment.
• Closing Costs: Fees paid at closing, such as title insurance, recording fees, and legal fees.
• Capital Improvements: Costs for significant enhancements that add value to the property, such
• Depreciation: If the property was used for rental purposes at any time, depreciation claimed during the rental period must be subtracted, such as a new kitchen or addition.
• Casualty Losses: Any losses from events like fires or storms that were not covered by insurance.
• Insurance Reimbursements: Payments received from insurance for damages must be subtracted if they were not used for repairs.
• Selling Costs: Costs associated with selling the property, such as real estate agent commissions.

It’s important to note that routine repairs and maintenance costs do not add to the cost basis, while improvements do. Work with an experienced accountant to accurately calculate your cost basis and ensure you don’t overlook potential deductions.

Once you know your cost basis, you can calculate how much your capital gains tax will be.

Depreciation Recapture and Paying Capital Gains Taxes

Depreciation is a method used to allocate the cost of a tangible asset over its useful life. For real estate, depreciation reflects the property’s gradual wear and tear, decay, or obsolescence. The IRS allows property owners to deduct a portion of the property’s value annually for tax purposes if the property is used for business or rental purposes. Therefore, it can apply to a second home, especially if the property functions as a vacation home rental property.

For residential rental properties, the IRS requires you to depreciate the building over 27.5 years using the straight-line method, which means you divide the property’s cost basis (excluding land) by 27.5 to determine the annual depreciation expense.

When you sell a rental property, the depreciation taken during the period you owned the property affects your capital gains calculation. This concept is known as “depreciation recapture.” Any claimed depreciation gets subtracted from your cost basis, increasing your profit.

Potential State and Local Taxes

In addition to Federal capital gains taxes, you may encounter various state and local taxes when selling your second home. These can vary significantly depending on the location of the property. Most states impose an income tax on the capital gains from the sale of a second home.

Some municipalities and counties also impose an additional local income tax on capital gains. For example, Florida does not have a state income tax, but it does impose a documentary stamp tax on the transfer of real estate, which is typically 0.70% of the sale price.

Certain states impose additional surcharges on capital gains, particularly for high-income earners or high-value properties. For example, New York has additional taxes for high earners and properties sold over a certain threshold.

Additional taxes to keep in mind include:

• Transfer taxes
• Recording fees
• Unpaid property taxes

How to Reduce Capital Gains Tax on a Second Home

No one likes paying more in taxes than necessary. Fortunately, there are some strategies you can implement to reduce how much you owe in capital gains tax.

Adjust the Cost Basis

Most private second homeowners don’t fully understand the cost basis of their assets and how they can be adjusted. Your cost basis is a major determinant in profit and taxable gain. An adjusted cost basis includes the costs incurred during the purchase of the property, such as title fees, legal fees, and other closing costs, plus any significant improvements made to the property.

Therefore, owners of investment property or second residences should accurately track invoices and receipts for monies spent on major improvements such as renovating the kitchen or installing a new roof. These expenses can increase your cost basis and reduce your tax liability.

Convert Your Second Home into a Primary Residence

Under the right circumstances, a second home can be converted into a primary residence and, therefore, would qualify for a primary residence capital gains tax exclusion. To qualify for the exclusion, you must meet both the ownership and use tests. This means you must have owned the home and lived in it as your primary residence for at least two of the five years preceding the sale, but the two years do not need to be consecutive.

If you have the flexibility to move into your second residence and turn it into your primary residence before selling, you can avoid capital gains taxes within the exclusion limitations. With this strategy, singles can exclude up to $250,000 of capital gains on their primary residence, and married joint-filing couples can exclude up to $500,000.

Use a 1031 Exchange

A 1031 exchange (also known as a like-kind exchange) is one of the most widely used tax deferral strategies. It is defined under Section 1031 of the Internal Revenue Code (IRC) and allows real estate investors (and second-home owners) to defer paying capital gains taxes when they sell an investment property and reinvest the proceeds into another like-kind property.

For a property to qualify for a 1031 exchange, the properties involved must be like-kind. This definition is broadly interpreted in real estate; for instance, you can exchange a rental house for a commercial building, vacant land for an apartment complex, etc.

Because a second home qualifies as an investment property (even if it is not a rental property), it can be exchanged for another investment property. Using a 1031 strategy helps owners avoid paying immediate capital gains tax until the asset is divested. Many real estate investors use this strategy to continually reinvest profits from a real estate sale into other properties to grow their investment portfolio.

If you plan to use a 1031 tax strategy, here are some things to keep in mind:

• You Must Use a Qualified Intermediary (QI): The IRS requires a QI to facilitate the exchange. The QI holds the sale proceeds from the relinquished property and uses them to purchase the replacement property. The investor cannot take possession of the cash proceeds at any point during the transaction, so a QI needs to be appointed before the sale is complete.
• There are Time Restraints: You have 45 days from the sale of the relinquished property to identify potential replacement properties and 180 days from the sale of the relinquished property to complete the purchase of the replacement property.
• Boot: Any cash or non-like-kind property received in the exchange is considered “boot” and is subject to capital gains taxes. This can happen if the replacement property is of lesser value or if there is leftover cash after the exchange.

1031 exchanges are complex transactions that must adhere strictly to IRS regulations. Work with a knowledgeable QI and a tax advisor to ensure compliance and optimize tax benefits.

Strategic Selling and Tax Planning for Your Second Home

Selling a second home comes with tax implications and considerations that can be higher than when selling a primary residence. The potential tax burden can be significant, especially if the property has appreciated substantially. Owners must understand the tax consequences of selling a second home and strategies to minimize tax exposure before deciding to list.

Don’t try to figure it out yourself. When capital gains tax is involved, it’s crucial to get professional guidance. An experienced real estate agent who understands second homes and investment properties can provide invaluable guidance. They can help you strategize to maximize your sale price and connect you with tax advisors who can optimize your tax situation.

For expert assistance in selling your second home, start with FastExpert. FastExpert connects you with top-rated real estate agents, so you know you are working with the right professional to help sell an investment property. Visit FastExpert today to find an agent who can provide the guidance and support you need for a successful sale.