Whether it's due to a market drop or a change in lifestyle, selling a vacation home comes with a different set of rules than a primary residence. There aren't nearly as many tax breaks from the government because vacation homes are considered a luxury asset. It helps to know ahead of time how the taxes work before putting the house up on the market.
When it comes to a primary residence, the government gives people a fairly generous benefit for pocketing the appreciation value of their home. However, a second or a vacation home is treated the same as a traditional asset such as a stock. This means that if the home has increased in value, the seller will be taxed based on the appreciation amount.
While the seller is allowed to deduct everything from closing costs to major home improvements, they may be taxed at a full 20 percent of the gain. This means that if the home jumps from $500,000 to $1 million in just a year, the owner would likely have a full $100,000 taken out in taxes. The percentage of capital gains works on a progressive scale based on the income of the owner, with the standard amount being 15 percent.
Rules for Depreciation
For those who rent out their home for part of the year, depreciation can have an impact on the final total for capital gains—even if the home has steadily increased in value over time. A person is allowed to claim depreciation based on wear and tear from rental guests while they own the home to avoid higher income taxes. However, the depreciation will also make capital gains more severe because the starting amount is based on the final claimed depreciation value.
So for owners who spend $150,000 on a property and claim $30,000 in depreciation, their starting point for capital gains will be $120,000, as opposed to $150,000. If the property sells for $200,000, that's $80,000 worth of capital gains instead of $50,000. Homeowners are also allowed to use capital losses to offset their capital gains. So if the seller's primary residence is worth less than what they paid, but their vacation home has appreciated, they could sell both homes to balance out their total taxes.
Further Options When Selling a Vacation Home
Sellers who don't want to pay capital gains on a home that's drastically appreciated may want to make the home their primary residence, swap it out for another investment property, or leave it as a legacy for any descendants. Those who make their vacation home their residence can qualify for a $250,000 ($500,000 for joint owners) capital gain deduction if they live in the home for at least two out of five years of ownership. Alternatively, they can use a 1031 exchange, where they purchase a similar property of equivalent value.
This doesn't eliminate the need for capital gains entirely, but it does delay it until the final sale of a property. If leaving it to descendants, the children will get a new base amount of the home according to the market value at the time of inheritance.
Another option is to either not sell the rental or consider taking on a partner. Not selling would involve considering the current real estate market, interest rates and prices for vacation homes. Simply put, even with tax considerations, it might be more advantages to wait a year or two before selling.
As to taking on a partner, there are tax advantages and considerations in only selling a portion of your interest in the vacation home. By only selling a portion, one can often take advantage of selling the property, i.e. cash proceeds, but yet keep a portion of the property.
Talking to a professional is often the best way to navigate taxes at the time of a sale. A 1031 exchange, for example, is fraught with complications and rules. However, the more aware sellers are of the many rules and options available to them, the more likely it is they can maximize the returns on their Kenai home investment.