Strategies for Real Estate Investors with Second Homes
Owning a vacation home can be both a lifestyle luxury and a potential investment. But when it comes time to sell, many owners are surprised by the potential tax liability, particularly capital gains tax on any appreciation if your vacation home has significantly increased in value. Understanding how to reduce or defer capital gains tax can help preserve your returns.
Let’s walk through the key strategies available to real estate investors and second-home owners who want to minimize tax exposure when selling a vacation property.
First, Know How Capital Gains Are Calculated
Capital gains are calculated by subtracting your adjusted basis (original purchase price plus capital improvements minus any depreciation) from the sale price (less selling costs).
If you bought a vacation home for $400,000 and sold it for $750,000, your gain would be $350,000—subject to capital gains tax unless an exclusion or deferral applies.
1. Convert the Vacation Home to a Primary Residence
One way to reduce capital gains tax is by converting the vacation home to your primary residence before selling. Under current IRS rules, single taxpayers can exclude up to $250,000 of gain from the sale of a primary home, while married couples filing jointly can exclude up to $500,000.
To qualify:
- You must own the home for at least two years.
- You must have used it as your primary residence for at least two of the past five years before the sale.
Note: A portion of the gain may still be taxable under IRS allocation rules if the home was previously used as a rental or vacation property. Also exclusion can only be used once every two years. Depreciation taken while the property was used as a rental cannot be excluded and is subject to recapture, taxed at a maximum rate of 25%.
2. Use a 1031 Exchange (If It Was a Rental)
If your vacation home was used as a rental property—even part-time—and held for investment purposes, you may qualify for a 1031 Exchange. This allows you to sell the property and defer capital gains taxes by reinvesting the proceeds into another like-kind investment property.
Requirements include:
- The property must have been held primarily for investment. Limited personal use is allowed, but must comply with IRS safe harbor rules. Personal use must not exceed the greater of 14 days or 10% of the number of days the property was rented at fair market value in each of the two years before the exchange..
- You must identify a replacement property within 45 days of selling the relinquished property..
- You must close on the new property within 180 days.
This strategy benefits investors transitioning from active property management to passive vehicles like Delaware Statutory Trusts (DSTs).
Important Considerations: A 1031 exchange involving a vacation rental property must meet specific IRS requirements to qualify. Personal use restrictions, documentation errors, or missed deadlines can result in disqualification and immediate tax liability. Additionally, investing in DSTs involves illiquidity, market risks, and sponsor due diligence.
3. Gifting or Inheritance Planning
For long-term planners, gifting or passing the property through inheritance may reduce or eliminate exposure to capital gains. When inherited, the property typically receives a step-up based on fair market value, which can significantly lower or eliminate taxable gain if the property is sold shortly after inheritance.
While passing a vacation property through inheritance can offer a significant tax advantage via a step-up in basis, gifting the property during your lifetime does not provide this benefit and may lead to capital gains liability for the recipient. Inherited assets are typically valued at fair market value on the date of death, potentially minimizing taxable gain if sold soon after. In contrast, lifetime gifts retain the original owner’s basis, possibly triggering substantial taxes upon sale. Understanding these distinctions is essential when choosing the most tax-efficient strategy for your estate and investment goals.
Final Thoughts
Selling a vacation home doesn’t have to mean a steep tax bill—especially if you plan. Several strategies exist to minimize capital gains tax, whether you convert the home to a primary residence, structure the sale as a 1031 Exchange, or incorporate it into your estate plan.
Before acting, consult a tax advisor or financial professional familiar with real estate transactions to determine which path fits your goals. With the right approach, your vacation home can serve your lifestyle and legacy.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
