How do I avoid paying tax on a second home?

There are various ways to avoid capital gains taxes on a second home, including renting it out, performing a 1031 exchange, using it as your primary residence, and depreciating your property.

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Many people invest in second homes for both personal and financial reasons. Some homeowners want a vacation getaway they can escape to on the weekends. Other buyers want to rent out the space and use the investment income to grow their wealth. However, there may come a time when you find it necessary or desirable to sell that second home. While you can reap the profits of the home sale — especially if the property has increased in value over the years — you will likely also be subject to the capital gains tax. Fortunately, you can prepare for these taxes and can even take steps to mitigate them. Here is what you need to know about paying capital gains taxes on a second home before you decide to sell.

What is a capital gains tax?

When you sell property at a profit, the IRS considers that profit to be part of your taxable income. A capital gains tax is levied on any profits (gains) that you made due to the appreciation of the property you sold. The capital gains tax isn’t just applicable to property. It can also be levied against the sale of other high-priced items, like a boat or luxury vehicle. For example, if you bought a $300,000 home, and later sell it for $400,000, your taxable capital gain on that transaction is the $100,000 profit. That is the amount that the IRS will tax. This is a simplified example just to show how the tax works. You can also deduct other costs and expenses related to selling the home. If you paid a six percent Realtor commission on the home sale ($24,000 on a $400,000 listing) then you would only reap $76,000 in taxable profits. If you spent $6,000 to renovate the house before selling it, your taxable profits drop to $70,000. Just like with income tax, the capital gains tax is not a flat fee. Rather, it is a percentage of the profit. The percentage will change based on your tax bracket. Some states also have their own state capital gains tax. As of February 2021, the following states do not charge their own capital gains tax:

Alaska

Florida

Nevada

New Hampshire

South Dakota

Tennessee

Texas

Washington

Wyoming

Selling a Primary Residence Vs. Selling a Second Home

If the property you sold is your primary residence, you will most likely pay very little or no tax. That is because the IRS has a primary residence exclusion for capital gains taxes. If you are single, you can exclude as much as $250,000 in profit from the sale of your primary residence. If you’re married and filing jointly, you can exclude $500,000. However, you cannot exclude a second home, regardless of whether it is a vacation home or rental property. You will have to pay a capital gains tax on the sale of your second home. Depending on how long you’ve owned your second home, your taxes will be a short-term capital gains tax or a long-term capital gains tax.

Short Term Capital Gains Tax

If you sell an investment property that you have owned for less than a year, it will be subject to the short-term capital gains tax. It will be taxed at the same rate as the rest of your annual income. Depending on your tax bracket, this can be as high as 37% of the gains. The goal of the short-term fee is to tax home flippers and other professionals who buy and resell items quickly. For example, an investor can buy a house, fix it up, and resell it within a year for a profit. These profits are taxed. The short-term capital gains tax applies to other resellers, ranging from people who find rare antiques to mechanics who fix up custom cars and motorcycles.

Long Term Capital Gains Tax

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On the other hand, if you are selling a second home that you have owned for more than a year, the capital gains tax will be lower than your income tax bracket. Long-term capital gains in 2022 are taxed at 0%, 15%, or 20%, depending on your income. There are tools online that you can use to estimate the capital gains taxes on a second home. SmartAsset has a simple tool where you can input the initial value of the property, the sale value, the length of ownership, and your income. The site will then break down the different taxes you need to pay and can offer tips on saving money. Even knowing your estimated capital gains tax can prepare you to file accurately in the spring.

2022 Long Term Capital Gains Tax Rates Per Bracket

Your long-term capital gains tax rate will depend on both your income and filing status. Here is what you need to know when filing in 2023 for the 2022 tax year. There is a zero percent tax rate if you meet one of the following criteria:

You are single and made under $41,675

Are married (filing jointly) and made under $83,350

Are married (filing separately) and made under $41,675

You are the head of the household and made under $55,800

There is a 15 percent tax rate if you meet one of the following criteria:

You are single and made between $41,676 and $459,750

Are married (filing jointly) and made between $83,351 and $517,200

Are married (filing separately) and made between $41,676 and $258,600

You are the head of the household and made between $55,801 and $488,500 There is a 20 percent tax rate if you meet one of the following criteria:

You are single and made more than $459,750

Are married (filing jointly) and made more than $517,200

Are married (filing separately) and made more than $258,600

You are the head of the household and made more than $488,500

Can I avoid paying capital gains taxes on the sale of a second home?

Yes, you may avoid paying some or all of your capital gains taxes. However, there are very strict guidelines that you will have to follow.

Minimize Your Net Profit

If you bought your second home for $200,000 and sold it for $300,000, then your taxable capital gain is $100,000, right? Not necessarily! The key here is that the capital gains tax on the sale of the second home applies to the net profit, not the difference in purchase price and sale price. Any money you invested to renovate or repair your second home can be deducted from the profit. If you put in a new roof for $10,000, then your taxable gain is down to $90,000. You can also deduct costs associated with the purchase and sale of your second home. Realtor commissions, inspections, origination fees, etc. Say you spent $5,000 in acquisition fees to purchase the home, and paid $20,000 in agent commissions and other fees at the sale. Then you can deduct another $25,000 from your profit. Your taxable capital gain is now down to $65,000. This doesn’t mean you should eliminate all of your profits on renovations. It does mean that you should carefully save your receipts and track your expenses throughout this process. You will want accurately file your taxes and you may need to prove the validity of these expenses in the rare event that your taxes are audited. Compare Agents. Save Thousands. An UpNest Network Agent can help you with purchasing your second home.

Make Your Second Home Your Primary Residence

Remember, you only have to pay that capital gains tax on the sale of a second home. What is the difference between a primary residence and a second home? For a home to qualify as your primary residence, you must have lived in it for two of the past five years, and those years don’t have to be consecutive. If you lived in the house for 18 months when you first purchased it, and less than five years have passed, then you only have to live in it for six more months for it to be considered your primary residence. Living in your second home for an extended period may not be ideal for a number of reasons: its location, the size of the home, etc. But if you can swing it, you might be able to save a large amount of money on taxes. Keep in mind that you can’t have used the primary residence exemption in the past two years to qualify. If you sold your primary residence last year, you may need to wait two years before you can sell this home and qualify for the exemption.

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During this time, you will also want to gather proof that the home was your primary residence. Again, this protects you in the rare event of an audit. This evidence can include a sworn statement that the home is your primary residence or formal documents like a driver’s license or tax forms with the address listed.

Consider a 1031 Exchange

What will you be doing with the profit from your second home? If you don’t have an immediate need for the money, you can use it to buy another second home. This is known as a 1031 exchange. When this occurs, you will not have to pay taxes on the profit you made from the sale.

What are the rules for a 1031 Exchange?

The first set of qualifications concerns the profit from the sale of the home. You cannot touch the proceeds from the sale of the second home. The money must go directly into an escrow account. There is a 45-day limit from the sale of the first property to find the next property and make an offer. You have 180 days from the sale to close on the second property. If any of those conditions aren’t met, you will have to pay the capital gains tax on the sale of your second home. In addition, a 1031 exchange can only take place between two rental properties. In order for a home to be considered a rental property, it needs to meet certain conditions:

You must have owned the home for over two years.

You must have rented the property for at least 14 days in each of the previous two years. The property cannot be used as a vacation home for more than 14 days or 10% of the days it was rented in each of the previous two years. The same conditions must be met on the replacement property for the first two years that you own it. Owning a second property, whether it’s a vacation home or a rental property, can be a profitable investment. Just be sure that you are prepared for the capital gains tax on the sale of a second home when you are ready to move on.

Find Your Second Home With an UpNest Network Agent

If you are thinking of selling your second home, an UpNest Network Realtor can help. Use our free service and you will receive proposals from top-notch local real estate agents who are ready to work with you. You can compare proposals to save on commission, view recent reviews, and pick the agent best suited for your real estate needs. Plus, you never have to choose the agents we recommend. UpNest is a low-stress, low-pressure way to find the right Realtor for you. Try our services today.

upnest.com - Can You Avoid Capital Gains Taxes When Selling a Second Home?