Selling a vacation home will come with different tax implications than selling a primary home will. Because a second home is defined as a luxury good, the government is far less forgiving about its appreciation. Learn more about how to calculate taxes and the options available to defer those taxes.
The Truth About Capital Gains
Capital gains refer to any asset that appreciates over time. Once the owner has determined exactly how much the asset has appreciated, they're then taxed on the profits. Capital gains are more commonly referred to in the stock market rather than the real estate market, but the tax code applies to any asset of value.
The amount a person pays in capital gains is dependent upon their total yearly income. If a person's income is low enough, they may not have to pay any capital gains at all. The maximum amount for top income earners is 20% and the average is 15%.
How to Factor In Expenses
When it comes to calculating the appreciation value, homeowners need to take into account a variety of expenses. Sellers are allowed to deduct home-related expenses from their appreciation value, including closing costs, marketing efforts to sell the home (e.g., professional photos, open house advertising, etc.), and the cost for major renovations and repairs to the home.
Sellers are also allowed to deduct capital losses from their yearly tax statement. (Capital losses refer to any asset that depreciates over time). Some owners will sell their primary home and vacation home in the same year if the primary has depreciated while the second home has appreciated at roughly the same rate. If a second home has severely appreciated in value, some homeowners will move from their primary into their second home for at least two years to avoid paying capital gains. Capital gains do not apply to co-owned primary residences (up to $500,000).
If the second home is primarily a rental property, it's easy for sellers to go a little overboard with tax depreciation. The more depreciation they claim to the property, the less they have to pay in income taxes. However, depreciation works to boost capital gains. The government will use the claimed depreciation value to calculate capital gains, which can severely inflate the appreciation value based on the sale price. Let's say a seller originally purchases a home for $100,000, claims $15,000 of depreciation during ownership, and then sells the home for $200,000. Capital gains would total $115,000 as opposed to $100,000.
There are additional options for those who want to avoid capital gains:
- 1031 exchange: North Edison home sellers do not need to pay for capital gains if they purchase a property that is similar in value to the one sold. Keep in mind, this does not eliminate capital gains, but it can defer the taxes if the seller wants to invest in another property.
- Legacy: Sellers can also pass down their property to their children if they wish. However, when they make the transfer to their children's name, the value of the home will be based on a new assessment as opposed to the original purchase price.
Selling a vacation home can be complicated if it's appreciated in value, but there are ways to limit how much a seller pays in capital gains. Understanding how each option works will make it easier to pick the right path.