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Primary residences qualify for a valuable capital gains tax exclusion, while gains on an investment property are almost always taxable. And as you might expect, the rules for capital gains taxes on a second home fall somewhere in the middle.
With that in mind, here’s a rundown of why the home sale exclusion usually doesn’t apply to second homes, how much capital gains tax you can expect when you sell your second home, and some other rules and tips you should know.
The home sale gain exclusion doesn’t apply to second homes (in most cases)
Typically, capital gains tax is assessed when you sell an asset for a net profit, but the IRS has one big exception for the sale of real estate. Known as the home sale gain exclusion or primary residence exclusion, this rule says that upon the sale of a primary residence, as much as $250,000 in capital gains can be excluded from taxation for single tax filers ($500,000 for married filing jointly).
The key phrase in that last paragraph is primary residence. Second homes typically do not qualify for this exclusion.
However, it’s worth mentioning that the IRS defines the term primary residence as somewhere that you lived full-time for at least two of the five years preceding the sale. So, if your second home served as your primary residence for any two years out of the previous five, it could still qualify for the exclusion. Of course, this isn’t terribly common, so most second-home sales are subject to capital gains taxation.
How much capital gains tax will you have to pay?
The amount of capital gains tax you’ll pay on the sale of a second home depends on three main factors:
- How long you owned the home
- Your capital gains tax rate
- How much your net profit was
So, let’s look at these one at a time.
Short-term or long-term capital gains
A capital gain is considered to be a short-term gain if you owned the asset for a year or less. A capital gain is classified as a long-term gain if you owned the asset for more than a year. In the case of second homes, the vast majority of sales fall into the latter category, but it’s entirely possible to sell a property after less than a year of ownership.
If you owned your second home for a year or less, your capital gain will be taxed as ordinary income at your marginal tax rate or tax bracket.
Capital gains tax rates
If you owned your second home for more than a year, any capital gain will be taxed according to the long-term capital gains tax rates, which are 0%, 15%, or 20%, depending on your income. In all cases, the long-term capital gains rates are lower than the corresponding marginal tax rates on ordinary income.
For 2020, here are the three capital gains tax income tax brackets for the various tax filing statuses. Remember that these figures represent taxable income:
|Long-Term Capital Gains Tax Rate||Single Filers (Taxable Income)||Married Filing Jointly||Heads of Household||Married Filing Separately|
|0%||$0 – $40,000||$0 – $80,000||$0 – $53,600||$0 – $40,000|
|15%||$40,000 – $441,450||$80,000 – $496,050||$53,600 – $469,050||$40,000 – $248,300|
|20%||Over $441,450||Over $496,050||Over $469,050||Over $248,300|
Cost basis and net selling price
Finally, you’ll need to determine just how much of a gain you had, which can be easier said than done. For example, let’s say that you bought a beachfront condo for $200,000 and sold it for $300,000. Sounds like a $100,000 gain, right?
However, when you consider that you paid $5,000 in origination fees and acquisition costs to buy it, and $20,000 in real estate agent commissions and other fees when you sell it, your actual profit on the property becomes significantly lower.
This is where the concepts of cost basis and net selling price come in. Your cost basis in a property is the amount of money you spent to acquire it, including your acquisition costs and any capital improvements you made. For example, if you spent $190,000 on a property, $10,000 on acquisition expenses, and $25,000 renovating the kitchen, your cost basis would be $225,000.
Your net selling price is the actual amount of money you receive from the sale of a property. This takes things like sales commissions and closing fees into account.
Your capital gain on the sale of your second home is the difference between the property’s cost basis and net selling price.
An example of capital gains tax on a second home
Let’s look at a hypothetical example. You bought a condo at the beach in 2012 for $250,000. You spent $10,000 on acquisition-related costs and also used $20,000 to renovate a bathroom after closing. You determine that the condo's fair market value in 2020 is $400,000. To sell it, you'd pay $24,000 in sales commissions and another $3,000 in various closing costs. You are married and file a joint tax return, and you anticipate that your taxable income in 2020 (excluding the sale of the property) will be $100,000. We’ll assume you don’t qualify for the home sale gain exclusion, as the property was never your full-time residence.
Based on this information, you’re looking at a long-term taxable capital gain. Your cost basis in the property is $280,000, and your net proceeds from the sale are $373,000. This gives you a net capital gain of $93,000.
Since your taxable income puts you firmly within the 15% long-term capital gains tax bracket, you can expect to pay capital gains tax of $13,950 on the sale.
It’s also important to mention that this just refers to federal taxes. You may owe other taxes on the state or local level upon the sale of a second home.
What if you’ve depreciated the property?
If you’ve rented out your second home, you may have taken real estate depreciation deductions while you owned the property. In the case of a second home, you can depreciate the property for the proportion of the days it was used as a rental property during any given year in order to help reduce your taxable rental income. For example, if you used your second home for 30 days during the year and rented it out for 70 days, you can take 70% of the annual depreciation deduction that would apply to an investment property.
If you’ve claimed depreciation, it adds another capital gains tax liability known as depreciation recapture. The short version is that your cumulative depreciation on a property is taxed at a flat 25% rate upon the sale. So, if you’ve claimed a total of $40,000 in depreciation while you owned your second home, it could add $10,000 to your tax bill upon the sale. This applies regardless of whether you qualify for the home sale gain exclusion mentioned earlier.
Also, if the property has been mostly used as a rental property and you plan to use the sale proceeds to buy another second home to use primarily as a rental property, you may be able to use a 1031 exchange to defer capital gains tax (and depreciation recapture) on the sale. Admittedly, there is quite a bit of gray area in the rules when it comes to 1031 exchanges and properties that you’ve used for personal reasons, and there is a fine line between investment properties and second homes in the eyes of the IRS, so check with an experienced professional before trying to use this strategy.
If in doubt, call in the pros
Tax issues when it comes to real estate sales can be rather complex. For example, maybe you’re having a difficult time figuring out your cost basis or can’t determine if your second home qualifies for the home sale gain exclusion. Or maybe you’ve rented out your second home quite a bit and want to know if it qualifies for a 1031 exchange.
In situations like these, it’s very important to defer to the professionals. Capital gains on second home sales can easily extend into the hundreds of thousands of dollars, and like most high-dollar tax issues, the IRS tends to pay pretty close attention. So, be sure to seek the advice of a tax professional for anything you’re uncertain about -- it can be well worth the money to get it right.
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