Capital gains tax applies when you sell an asset for more than you paid for it. While the IRS typically offers an exclusion for capital gains from the sale of a primary home, the rules are a little different when selling a property that you don’t live in full-time. Before unloading a vacation or rental property, it’s important to understand how capital gains on the sale of a second home work. A financial advisor may be able to help if you’re selling your second home. Try using SmartAsset’s free advisor matching tool today to find advisors that serve your area.
Capital Gains Tax Exclusion
A capital gain represents a profit on the sale of an asset, which is taxable. The IRS allows taxpayers to exclude certain capital gains when selling a primary residence. For 2022, the capital gains tax exclusion limit for the sale of a home is $250,000 for single filers or up to $500,000 for married couples who file a joint return. So you wouldn’t owe capital gains tax on any profits from the sale, up to the exclusion limit allowed for filing status.
To qualify for this exclusion, each owner of the home must meet an ownership test and a use test. You pass these tests if you’ve owned and used the home as your primary residence for at least two out of the five years prior to the sale. You’re typically not eligible for the exclusion if you excluded gains from the same of another home during the two years prior to selling your current home.
Capital Gains on Sale of Second Home
The IRS treats second homes differently when calculating capital gains tax. Second homes that are not used as primary residences, including vacation homes and investment properties, are considered to be capital assets under IRS rules. That means if you don’t pass both the ownership and use tests for the property, as mentioned earlier, then no capital gains tax exclusion is allowed.
The amount of capital gains tax you’ll owe on the sale of a second home depends on several factors, including:
- How long you owned the home
- How much of a profit you realize from the sale
- What you paid for the home
- Capital investments you made in the home
- Final sale price
- Filing status and income
- The applicable gains tax rate
Capital gains tax can be assessed at short- or long-term rates. The short-term capital gains tax is the same as your ordinary income tax rate as determined by your tax bracket. A gain is considered to be short-term if you held the asset for less than one year prior to selling it.
Calculating Capital Gains on Sale of a Second Home
To figure out how much you owe in capital gains tax when selling a second home, you’d need to first calculate the actual profit from the sale. This means determining your cost basis in the property, which simply means how much you paid to purchase it and how much you subsequently invested in it while you owned it.
So, let’s assume you purchase a vacation home 10 years ago for $200,000. You spend $25,000 making upgrades and improvements to the property. Five years later, the property is valued at $500,000 so you decide to sell. You pay $30,000 in commissions to your agent and the buyer’s agent, plus another $5,000 to close the sale.
Your cost basis is $225,000 ($200,000 to purchase it plus $25,000 in upgrades). You sell the home for $500,000, less the $35,000 you pay in commissions and closing costs. So the net proceeds come to $240,000. Unless you can show that you meet the ownership and use tests for the home, you’d owe capital gains tax on this amount.
Since you owned the home for 10 years, the long-term capital gains tax rate would apply. The rate you pay would depend on your income and filing status. For example, to qualify for the 0% capital gains tax rate you’d need to earn less than $41,675 for 2022. Meanwhile, if your income is above $459,750 you’d be taxed at the 20% capital gains rate.
How to Minimize Capital Gains Tax on the Sale of a Second Home
If you’re worried about getting hit with a large tax bill when selling a second home, there are some things you can do that might cushion the blow. Some of the options for minimizing capitals on sale of second home include:
- Renting out the property, which would allow you to treat it as an investment and claim depreciation and other deductions
- Increasing your cost basis with improvements or upgrades to reduce the amount that may be subject to capital gains tax
- Making the property your primary residence in order to qualify for the capital gains tax exclusion
- Deferring capital gains tax owed on the sale through a 1031 exchange, which would allow you to swap the property out for a like-kind investment
You can also use tax-loss harvesting to offset some of your tax liability from the sale of a second home. Tax-loss harvesting involves selling off assets at a lower price to offset capital gains.
This could help reduce your tax bill, but here’s what you need to keep in mind. Only like-kind gains and losses can be harvested. This means you can only offset short-term capital gains with short-term capital losses and long-term capital gains with long-term capital losses. So tax loss harvesting may not be enough to cancel out all of the gains from the sale of a second home.
Talking to a tax professional or your financial advisor can help you gauge whether selling a second home makes sense from a tax perspective. You can also discuss what to do with the proceeds from the sale of the home.
Capital gains tax is often unavoidable when selling a second home but that shouldn’t deter you from your plans if you feel the time is right to sell. Estimating how much you might pay using a capital gains tax calculator can help you develop the right strategy for carrying out the sale while minimizing what you might owe in taxes.
Tax Planning Tips
- Consider talking to a financial advisor about capital gains tax on the sale of a second home if you have a property you’re planning to sell. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Tax planning is an important part of investing and there are different ways to approach it. If you’re considering real estate as an investment, for example, you may choose to open a self-directed IRA to hold rental properties. A self-directed IRA is designed to hold investments that a typical IRA cannot, including real estate, precious metals and commodities.
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