Real estate markets are still surging in many parts of the country, especially in some popular travel destinations. If you're thinking about selling a vacation home that's increased dramatically in value, you might be rightly concerned about the tax hit. While the limited federal income tax gain exclusion break is still on the books, it's only available for the sale of a principal residence.
Basics of the Home Sale Gain Exclusion
Under current federal income tax law, homeowners can potentially exclude principal residence gains up to $250,000 or up to $500,000 for a married joint-filing couple. To take full advantage of the exclusion break, you must pass two tests:
1. Ownership test. You must have owned the property for at least two years out of the five-year period ending on the sale date.
2. 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:
It's possible that you could pass these tests for a property that's been used both as a vacation home and a principal residence.
There's also an "anti-recycling" test that you must pass to qualify for the home sale gain exclusion. Under this rule, 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 can't recycle the gain exclusion privilege until two years have passed since you last used it.
Furthermore, you can only claim the larger $500,000 joint-filer exclusion if neither you nor your spouse took advantage for an earlier sale within the two-year period. If a spouse claimed the exclusion within the two-year window but the other spouse didn't, the exclusion is limited to $250,000.
However, a vacation home will sometimes qualify for the gain exclusion break if you've also used the property as a principal residence. Here's an overview of the federal income tax rules for gains from selling a vacation home under three possible scenarios. Beware: The rules can be complicated!
Scenario 1: You've Never Rented Out the Vacation Home
This is the simplest scenario. Here, the principal residence gain exclusion break is unavailable. So, your profit will be treated as a capital gain and taxed accordingly.
If you've owned the property for more than a year and have never rented it out, you'll owe federal capital gains tax at the lower rates for long-term capital gains (LTCGs). The current maximum rate for LTCGs is 20%. But you'll owe that rate only on the lesser of:
- Your net LTCG, or
- The excess of your taxable income, including any net LTCG, over the applicable threshold.
For 2022, the thresholds for the 20% LTCG rate are:
- $459,750 for single people,
- $488,500 for heads of households, and
- $517,200 for married couples who file joint tax returns.
If you also owe the 3.8% net investment income tax (NIIT), the maximum effective federal rate on your net LTCG will be 23.8% (the 20% maximum LTCG rate plus another 3.8% for the NIIT).
If you're below the applicable threshold, the LTCG rate is 15% for most taxpayers. However, if you owe the NIIT, the effective rate is 18.8% (15% plus 3.8%). You may owe state income tax, too.
For example, Abe and Mary are married and report $800,000 of taxable income for 2022, consisting of a $500,000 LTCG from selling their vacation cabin and $300,000 of taxable income from other sources after allowable deductions. The excess of their taxable income over the applicable threshold is $282,800 ($800,000 minus $517,200). That amount of the $500,000 LTCG is taxed at the maximum 20% rate. The remaining $217,200 ($500,000 minus $282,800) is taxed at 15%. The couple will also owe the 3.8% NIIT on all or part of their LTCG and possibly state income tax, too.
Another married couple, George and Martha, report $900,000 of taxable income for 2022, consisting of a $350,000 LTCG from selling their mountainside vacation home and $550,000 of taxable income from other sources after allowable deductions. Since their taxable income before any LTCG exceeds the applicable threshold of $517,200, the entire $350,000 LTCG is taxed at the maximum 20% rate. Plus, they'll also owe the 3.8% NIIT on all or part of their LTCG and possibly state income tax, too.
Scenario 2: You've Rented Out the Vacation Home
In this scenario, you've probably deducted depreciation for rental periods. If so, you'll pay a 25% federal income tax rate on the amount of gain attributable to the depreciation write-offs (so-called unrecaptured Section 1250 gain). The unrecaptured Sec. 1250 gain amount will usually equal the cumulative amount of depreciation deductions claimed for the property over the years. Assuming you've held the property for over a year, the remaining gain is taxed as a LTCG.
Additionally, if you rented out the vacation home but also used it frequently 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 couldn't 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.
Conversely, if you rented out the vacation home but used it only occasionally 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 couldn't deduct currently due to the 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
There's potentially good news for people in this scenario: You might be able to claim the tax-saving principal residence gain exclusion break, depending on your situation. (See "Basics of the Home Sale Gain Exclusion" above.)
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 home sale gain exclusion. However, under current law, a little-known rule can reduce your otherwise allowable gain exclusion. Let's call the amount of gain that's made ineligible the "nonexcludable" gain.
Follow these three steps to handle the gain from your vacation home sale, assuming you owned the property for more than one year:
1. Determine your unrecaptured Sec. 1250 gain. Subtract from your total gain, any gain from depreciation deductions claimed against the property for any rental periods after May 6, 1997. Report that amount as unrecaptured Sec. 1250 gain on your federal income tax return for the year of the sale. It's subject to the 25% tax rate plus the 3.8% NIIT, if applicable. Carry the remaining gain to Step 3.
2. Calculate the nonexcludable gain fraction. The numerator of this fraction is the amount of time after 2008 during which you didn't use the property as a principal residence. This is so-called "nonqualified use." The denominator of the fraction is your total ownership period for the property.
Nonqualified use doesn't include temporary absences that aggregate to two years or less due to changes of employment, health conditions or other circumstances specified in IRS guidance. It also doesn't include times when the property wasn't used as your principal residence if those times are 1) after the last day of use as a principal residence, and 2) within the five-year period ending on the sale date.
3. Determine your nonexcludable gain. This portion of the gain equals the remainder from Step 1 multiplied by the nonexcludable gain fraction from Step 2. This amount should be reported as a LTCG on your federal income tax return for the year of the sale, subject to the 15% or 20% rates explained earlier, plus the 3.8% NIIT to the extent applicable.
The remaining gain after subtracting any unrecaptured Sec. 1250 gain (from Step 1) and the nonexcludable gain (from Step 3) is eligible for the principal residence gain exclusion, assuming you meet the timing requirements. (See "Basics of the Home Sale Gain Exclusion" above.)
Important: 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 break of $250,000 for single people or $500,000 for married couples who file jointly. Assuming you've owned the property for more than a year, the part you can't exclude will be taxed as a LTCG.
Here are two examples to illustrate how to allocate the gain for a vacation home that was used as a principal residence for part of the time it was owned.
First, Frank and Elle are a married couple who purchased a vacation home on January 1, 2007. They rented it out frequently in 2007 through 2015. Then, on January 1, 2016, they converted the vacation property into their principal residence and lived there together through the end of 2021. On January 1, 2022, they sold the property for a $700,000 gain, including $50,000 of depreciation deductions claimed for the 15-year rental period.
Here's how Frank and Elle would allocate their gain:
1. The $50,000 of gain attributable to depreciation deductions from rental periods should be reported as unrecaptured Sec. 1250 gain on their 2022 return. That amount is subject to the 25% tax rate plus another 3.8% if the NIIT applies. The remaining gain is $650,000 ($700,000 minus $50,000).
2. The period of post-2008 nonqualified use was 2009 through 2015. So, the numerator in the nonexcludable gain fraction is seven years. The denominator is the total ownership period of 15 years (2007 through 2021).
3. That means that the couple should report a nonexcludable gain of $303,333 (7/15 times $650,000) on their 2022 tax return. It's treated as a LTCG, subject to the rates explained earlier.
Frank and Elle can shelter the remaining $346,667 of gain ($650,000 minus $303,333) with their joint-filer $500,000 home sale gain exclusion.
Our final example involves James, a single person who bought his vacation home on January 1, 2013. On January 1, 2016, he converted the property into his principal residence and lived there until 2019. He then converted the home back into a vacation property and used it as such in 2020 and 2021. He sold the property on January 1, 2022, for a $540,000 gain.
Here's where things become even more complicated. First, James must deal with the post-2008 period of ownership as a vacation home (2013 through 2015). That period represents three years out of his total nine-year ownership period (2013 through 2021). The result is a nonexcludable gain of $180,000 (3/9 times $540,000), which must be reported as a LTCG on his 2022 tax return.
How should James treat the remaining gain of $360,000 ($540,000 minus $180,000)? Fortunately, the last two years of use of the property as a vacation home (2020 and 2021) don't count as periods of nonqualified use because they occurred 1) after the last 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, his use of the property as a vacation home in 2020 and 2021 doesn't increase his nonexcludable gain.
James can shelter $250,000 of his remaining $360,000 gain with his home sale gain exclusion. He must treat the remaining $110,000 of gain ($360,000 minus $250,000) as a LTCG on his 2022 return.
We Can Help
The tax rules when you sell a vacation home can be complicated. Before you put your second home on the market, contact your HK tax advisor to discuss the tax consequences of the transaction — and whether it makes sense to sell now or later. Taxes are just one factor to consider when putting your property up for sale.