With many real estate markets still surging, especially in sought-after places, you may be thinking about selling a vacation home that’s gone way up in value. The information below was provided to us from Bradford Tax Institute.

 

But what about the tax hit? Good question.

 

While the federal income tax home sale gain exclusion break is still on the books, it’s only available for the sale of a principal residence. That said, a vacation home will sometimes qualify for the gain exclusion break if you’ve also used the property as a principal residence.

 

This article explains in plain English the sometimes-complicated federal income tax rules for gains from selling a vacation home. Let’s get started.

 

Scenario 1: You Have Never Rented Out the Vacation Home

 

In this scenario, the vacation home is your second home and thus the principal residence gain exclusion break is obviously unavailable. Your profit will be treated as a capital gain and taxed accordingly.

 

If you’ve owned the property for more than one year and never rented it out, you’ll owe federal capital gains tax at the lower rates for long-term capital gains. The maximum rate for long-term capital gains is 20 percent. But you’ll owe that rate only on the lesser of (1) your net long-term capital gain or (2) the excess of your taxable income, including any net long-term capital gain, over the applicable threshold.

 

For 2022, the thresholds are $517,200 if you’re a married joint filer, $459,750 if you’re a single filer, and $488,500 if you use head of household filing status.

 

If you also owe the 3.8 percent net investment income tax (NIIT), the maximum effective federal rate on your net long-term capital gain will be 23.8 percent: the advertised 20 percent rate plus another 3.8 percent for the NIIT.

 

Thanks to the thresholds for the 20 percent rate, the advertised rate on long-term capital gains is often “only” 15 percent. But if you owe the NIIT, the effective rate is 18.8 percent (15 percent + 3.8 percent).

 

You may owe state income tax too

 

Example 1. You’re a joint filer with 2022 taxable income of $750,000, consisting of a $500,000 long-term capital gain from selling your highly appreciated beachfront condo and $250,000 of taxable income from other sources after allowable deductions. The excess of your taxable income over the applicable threshold is $232,800 ($750,000 – $517,200).

 

• The $232,800 is taxed at the maximum 20 percent rate.

 

• The remaining $267,200 ($500,000 – $232,800) is taxed at “only” 15 percent.

 

• You’ll also owe the 3.8 percent NIIT on all or part of your long-term capital gain (probably all).

 

• And you may owe state income tax too.

 

Example 2. You’re a joint filer with 2022 taxable income of $900,000, consisting of a $350,000 long-term capital gain from selling your upscale cabin in the mountains and $550,000 of taxable income from other sources after allowable deductions.

 

Since your taxable income before any long-term capital gain exceeds the applicable threshold of $517,200, the entire $350,000 long-term capital gain is taxed at the maximum 20 percent rate. You’ll also owe the 3.8 percent NIIT on all or part of your long-term capital gain (probably all), and you may owe state income tax too. Ugh! Sorry about that!

 

Example 3. You’re a single filer with 2022 taxable income of $400,000, consisting of a $200,000 long-term capital gain from selling your modest vacation home in a desirable area and $200,000 of income from other sources after allowable deductions.

 

Since your taxable income including the long-term capital gain doesn’t exceed the applicable threshold of $459,750, the entire $200,000 long-term capital gain is taxed at “only” 15 percent. You’ll probably also owe the 3.8 percent NIIT on all or part of your long-term capital gain, and you may owe state income tax too. But at least you dodged the 20 percent bullet. Could have been worse!

 

Scenario 2: You Rented Out the Vacation Home

 

In this scenario, you’ve probably deducted depreciation for rental periods. If so, you’ll pay a 25 percent federal income tax rate on the amount of gain attributable to the depreciation This unrecaptured Section 1250 gain will usually equal the cumulative amount of depreciation deductions claimed for the property over the years.

 

Assuming you’ve held the property for over one year, the remaining gain will be long-term capital gain taxed as explained earlier.

 

But there’s more

 

If you rented out the vacation home but also used it more than a little for personal purposes, it has probably been classified as a personal residence for federal income tax purposes. If so, you may have had rental losses that you could not deduct currently (disallowed losses) due to a special loss limitation rule. When you sell the property, you can apparently deduct the disallowed losses to the extent of the taxable gain.

 

We are not done yet.

 

If you rented out the vacation home but used it only a little for personal purposes, it has probably been classified as a rental property for federal income tax purposes. If so, you may have had rental losses that you could not deduct currently due to the dreaded passive activity loss (PAL) rules (suspended PALs).If so, you can generally deduct the suspended PALs when you sell the property.

 

Scenario 3: For a Time, You Used the Vacation Home as a Principal Residence

 

Here’s where it can get interesting—in a good way. You might be able to claim the tax-saving principal residence gain exclusion break, depending on your exact situation. Here’s how that could work.

 

Gain Exclusion Basics

 

Unmarried homeowners can potentially exclude from taxation principal residence gains up to $250,000, and married homeowners can potentially exclude up to $500,000.

 

Ownership and Use Tests

 

To take full advantage of the principal residence gain exclusion break, you must pass two tests: the ownership test and the use test.

 

• To pass the ownership test, you must have owned the property for at least two years out of the five-year period ending on the sale date.

 

• To pass the use test, you must have used the property as your principal residence for at least two years out of the five-year period ending on the sale date.

 

• If you’re married and file jointly, you qualify for the bigger $500,000 joint-filer exclusion if (1) either you or your spouse pass the ownership test for the property, and (2) both you and your spouse pass the use test.

 

As you can see, it’s possible that you could pass these tests for a property that has been used both as a vacation home and a principal residence. So far, so good. But stay with us.

 

Anti-Recycling Rule

 

The other major qualification rule for the home sale gain exclusion break goes like this: the exclusion is generally available only when you’ve not excluded an earlier gain within the two-year period ending on the date of the later sale. In other words, you generally cannot recycle the gain exclusion privilege until two years have passed since you last invoked the privilege.

 

You can claim the larger $500,000 joint-filer exclusion only if neither you nor your spouse took advantage of it for an earlier sale within the two-year period. If one spouse claimed the exclusion within the two-year window, but the other spouse did not, the exclusion is limited to $250,000. Once again, so far, so good. But there’s more.

 

Taxes on Profit That Can’t Be Sheltered with the Gain Exclusion

 

If you have a hefty gain from selling a vacation home, it may be too big to fully shelter with the gain exclusion— even if you qualify for the maximum $250,000/$500,000 break. Assuming you’ve owned the property for more than one year, the part you cannot exclude will produce the tax results explained earlier.

 

Warning: Little-Known Rule Can Reduce Your Gain Exclusion

 

Once upon a time, you could simply convert your vacation home into your principal residence, occupy it for at least two years, sell it, and take full advantage of the $250,000/$500,000 gain exclusion privilege. Those were the good old days.

 

Now, a little-known rule can reduce your otherwise allowable gain exclusion. Let’s call the amount of gain that’s made ineligible the “non-excludable gain.” Calculate the non-excludable gain from your vacation home sale as follows.

 

Step 1. From your total gain, subtract any gain from depreciation deductions claimed against the property for any rental periods after May 6, 1997. Report that amount of gain as unrecaptured Section 1250 gain on Schedule D of Form 1040 for the year of sale. Carry the remaining gain to Step 3.

 

Step 2. Calculate the non-excludable gain fraction. The numerator is the amount of time after 2008 during which you did not use the property as a principal residence, called “non-qualified use.”

 

Fortunately, non-qualified use does not include temporary absences that aggregate to two years or less due to changes of employment, health conditions, or other circumstances specified in IRS guidance.

 

Non-qualified use also does not include times when the property was not used as your principal residence if those times are (1) after the final day of use as a principal residence and (2) within the five-year period ending on the sale date. (See Example 5 below.)

 

The denominator of the fraction is your total ownership period for the property

 

Step 3. Calculate the non-excludable gain by multiplying the gain from Step 1 by the non-excludable gain fraction from Step 2.

 

Step 4. Report on Schedule D of Form 1040 the non-excludable gain calculated in Step 3. As explained in Step 1, also report any unrecaptured Section 1250 gain from depreciation. The remaining gain after subtracting the nonexcludable gain and any unrecaptured Section 1250 gain is eligible for the principal residence gain exclusion privilege, assuming you meet the timing requirements.

 

Example 4. You’re a married joint-filer. You bought a vacation home on January 1, 2001. On January 1, 2016, you converted the property into your principal residence and lived there with your spouse from 2016 through 2021. On January 1, 2022, you sold the property for a $600,000 gain, including $50,000 of depreciation deductions claimed for the 15-year rental period (January 1, 2001, through December 31, 2015).

 

You report the $50,000 of gain attributable to depreciation deductions from periods when you rented the place while it was a vacation home (unrecaptured Section 1250 gain) on your 2022 Form 1040. That gain is subject to a federal income tax rate of 25 percent plus another 3.8 percent if the NIIT applies.

 

Planning tip. You may be able to avoid the NIIT. See How Rental Property Owners Can Avoid the Net Investment Income Tax.

 

Your remaining gain is $550,000 ($600,000 – $50,000).

 

Your total ownership period is 21 years (2001-2021). The seven years of post-2008 use as a vacation home (2009-2015) result in a non-excludable gain of $183,333 (7/21 x $550,000). Report the $183,333 as long term capital gain on Schedule D included with your 2022 Form 1040.

 

You can shelter the remaining $366,667 of gain ($550,000 – $183,333) with your $500,000 joint-filer gain exclusion.

 

Example 5. You’re an unmarried person. You bought a vacation home on January 1, 2013. On January 1, 2016, you converted the property into your principal residence and lived there from 2016 through 2019.

 

You then converted the home back into a vacation property and used it as such for 2020 and 2021 before selling the property on January 1, 2022, for a $540,000 gain. Your total ownership period is nine years (2013-2021). The first three years of post-2008 use as a vacation home (2013-2015) result in a nonexcludable gain of $180,000 (3/9 x $540,000).

 

Report the $180,000 as long-term capital gain on Schedule D filed with your 2022 Form 1040.

 

You can shelter $250,000 of the remaining $360,000 gain ($540,000 – $180,000) with your $250,000 gain exclusion. Report the last $110,000 of gain ($360,000 – $250,000) as long-term capital gain on Schedule D filed with your 2022 Form 1040.

 

Key point. The final two years of use of the property as a vacation home (2020-2021) don’t count as periods of non-qualified use because they occur (1) after the final day of use as a principal residence (December 31, 2019) and (2) within the five-year period ending on the sale date (January 1, 2022).

 

Therefore, your use of the property as a vacation home in 2020 and 2021 doesn’t make your non-excludable gain any bigger. Fair enough.

 

Takeaways

 

The tax-code-defined vacation home rules come into play when you have both rental and personal use of a home. Thus, you can have tax-code-defined vacation homes in the city, in the suburbs, and in recreation areas.

 

If you have no combined rental and personal use of the home, the rules are easy. The property is one of the following:

 

• Rental property

 

• Second home

 

• Principal residence

 

But when you have both rental and personal use of the home, your tax life gets more complicated because you have entered the tax code’s vacation home section. In this situation, the property in a more complicated way is one of the following:

 

• Rental property

 

• Second home

 

• Your principal residence

 

• If it’s a principal residence, then the $250,000/$500,000 home sale exclusion is available when you sell.

 

 

If it’s simply a second home, you can’t use the exclusion and you pay taxes at capital gains rates—and you may suffer the NIIT as well.

 

If it’s a rental, you face the capital gains rules, NIIT, unrecaptured Section 1250 gain taxes, and release of some (if grouped) or all (if not grouped) passive activity suspended losses.

 

When you have rental use after 2008 and then convert the rental to your principal residence, you must use a rental/residence fraction to determine how you will be taxed.

 

 

May 17, 2022 | DWHuff Consulting

Check out our blog for more content to help achieve financial freedom. As we learn new things we frequently share and discuss.We offer something for everyone through various pod casts, blog posts and emails. To get David's Free Newsletter just Click "Get Newsletter" and enter your email address