When selling a second home or vacation home, the taxpayer will incur capital gains taxes on any gain. These taxes would be treated as long-term capital gains if the home was held for more than a year. Long-term capital gains have rates of 0%, 15%, and 20%, dependent on the taxpayer’s income.
There are ways to defer these gains. In this article, we’ll go over the taxes incurred on the sale of a second home and then look at how those taxes can be deferred.
Capital Gains Taxes On Sale Of Second Home
Let's first start with the primary residence exclusion rule. This rule will confirm which of the two homes is the primary vs. secondary home as defined by the IRS. The rule states that if you have lived in the home for two of the last five years, it is considered your primary residence. You can exclude up to $500,000 of gains if you are married and filing jointly and $250,000 for everyone else.
What do gains look like when a second home is involved? As an example, you purchased a second home on January 1, 2010, for $500,000. On January 1, 2015, you moved into the home and made it your primary residence. On January 1, 2017, you decided to sell the home for $750,000, a gain of $250,000. The home was owned for seven years (2010 - 2017). Five of those years do not qualify. The period of qualified use is then 2/7 x $250,000 = $71,428. Said another way, $178,572 does not qualify for the primary residence exclusion and would be taxed at the long-term capital gains rate.
As an aside, you can’t spend time in both homes and try to claim them as primary residences. Only one home can be claimed as your primary residence.
Deferring Capital Gains Taxes On Sale Of Second Home
Can you defer capital gains taxes on the sale of a second home? To take advantage of a 1031 exchange, which will allow for deferring gains taxes, the home must be an investment property. If you are not renting out the property, it isn’t an investment property.
This doesn’t mean you’re out of luck. There are a few rules to follow when converting your second home into an investment property. These rules fall under IRS Revenue Procedure 2008-16, which came out in 2008 and provided a safe harbor. There are three rules to follow:
- Holding period test — own property for a minimum of 2 years
- Rental test — at least 14 days of rental history in each of two years
- Personal use test — maximum of 14 days in each of the two years or 10% of rental history (whichever is greater)
The rental test must be at least 14 days each of two years and not an accumulation of days during one year (i.e., 28 days in one year). If you rent out the property for a month in year one and do not rent it in year two, that doesn't qualify.
If you aren't concerned about the second home's investment property status, you can rent the property for fewer than 15 days without needing to report the income. This is because the home isn't viewed as an investment property.
Getting back to the three rules, for the personal use test, if you have family members at the property, it’s best to count that has personal use, even if you were not there. The 10% rule means you can use the property for up to 10% of the period it is rented. For example, if you rented it for 200 days in year one, you can use it for 20 days.
You can rent the home to family, but they must be charged a market rate. Some have utilized this strategy and coupled it with the $15,000 per year gift tax exclusion.
Advantages of Second Home as Investment Property
Whether you consider the second home's investment property status as being an advantage probably depends on how much use you want from the second home. An investment property and a second home (vacation home) are two different things. An investment property can't be used in the same way as a second home. So if you want a second home that you can drop in at any time, going the investment property route probably won't work.
However, if you'd rather the second home generate income than be an unrestricted vacation home, there are a few advantages to consider. First is that you can defer taxes on gains by utilizing a 1031 exchange. The second is that you can deduct expenses.
By following the IRS Revenue Procedure 2008-16 rules mentioned above, you can defer gains on taxes through a 1031 exchange. A 1031 exchange for a second home (i.e., investment property) is executed in the same way as a 1031 exchange for an investment property that isn’t used for personal use at all.
For deductions, you can deduct mortgage interest on the second home. This doesn’t exclude deducting mortgage interest on your primary residence. Mortgage interest could be deducted up to a maximum of $1 million in mortgage debt if the home(s) was purchased before December 16, 2017. After that date, interest can be deducted on the first $750,000 of mortgage debt. Note that itemizing mortgage interest means you can’t take the standard deduction.
You can also deduct property taxes on an unlimited number of homes. If your home is energy efficient, there may be credits that can be taken as well.
Whether it is worth converting your second home into an investment property will depend on your personal financial situation and use of the home. You’ll want to work through the scenario with your tax advisor. If the gain on the second home is small, it might not be worth the hassle. Additionally, if you have other investment losses, they can help offset some of the home’s gain. Another tactic is to donate some of your profits to a charity. However, that will only reduce your overall tax liability but doesn’t eliminate capital gains taxes.
At the end of the day, if there are enough gains that it generates a sizable tax bill, considering the investment property route and doing a 1031 exchange can pay off.