*This post has been updated to reflect tax changes

Considering selling your second home? In tax terms, a second home is regarded as an investment property, not a principal residence. It isn't treated the same and may cost you more in taxes. 

Let’s look closer at the tax consequences of selling a second home and dig into some ways to make the tax bite a bit smaller.

Defining the Capital Gains Tax

Capital gains are the profits you earn when you sell a capital asset. Capital assets include real estate (except for your primary residence), stocks, bonds, coin collections, and jewelry. As with any money you earn, the IRS wants a piece of it. Fortunately, you only pay taxes on the profit, not the total selling price.

Capital gains taxes are only due after the asset is sold, which turns it into realized capital gains. Any assets that you hold are considered unrealized capital gains. Realized capital gains are taxed differently depending on how long you hold the assets.

Profits from assets that you held for less than one year are considered short-term gains and are taxed like income. You base it on your income tax bracket just like you do for wages. Profits from assets you held for more than one year are treated as long-term gains and subject to a different tax framework.

Capital gains can be offset by capital losses. A capital loss is what you have when you sell an asset for less than you paid for it (also called your basis). Handled correctly, you can reduce your capital gains tax closer to zero if you have the appropriate amount of capital losses, which we discuss later in this post.

Now, let’s dig into the weeds a bit.

Capital Gains 101

A capital asset is anything you own and use for personal or investment purposes, including real estate, your home, stocks, furniture, that sort of thing. When you sell a capital asset, the difference between your basis and the selling price is either a capital gain or capital loss. 

If you received that asset as a gift or inheritance, these rules don’t apply. You need to consult a different section of tax law. 

Here are some more terms for you.

• Net capital gain is the amount by which your net long-term capital gain for the year is more than your net short-term capital loss for the year.
• Net long-term capital gain is your long-term capital gain reduced by your long-term capital losses.
• Net long-term capital losses include any unused long-term capital losses that you carried over from previous years. 

To determine how long you held an asset, count from the day after the day you acquired your asset up to and including the day you disposed of it (sold it).

Capital gains are taxed at 0%, 15%, or 20%, according to your filing status and taxable income level. For 2021, the thresholds are as follows. 

The thresholds increase for 2022.

The Tax Impact of Selling a Second Home

A second home that is not your primary residence is counted as any other investment real estate. A second home is a vacation home or rental property for many people. It's possible you purchased it for its depreciation value to offset other taxable gains.

In general, you pay higher taxes on the capital gains from selling a second home than you pay when you sell a primary residence. However, you can tweak things to your advantage.

A primary residence is one which you own and reside in for at least two years. The IRS does not require those two years to be consecutive. Plus, they tax a primary residence differently, especially upon its sale.

If you file single, $250,000 of capital gains on the sale of your home are excluded from your taxable income. If you are married filing jointly, the threshold goes up to $500,000.

Say you pick up a house to use for a second residence or rental property. You don’t want to incur capital gains as charged for real estate property. What can you do?

You can live in the residence for a year, rent it out for however many years you like, then move back in for another year. You satisfy the two-year requirement for the residence to be considered primary and taxed lower than investment property.

Once more thing — you can add the costs of any significant repairs and improvements to the home to the price of the house, reducing your tax burden even further.

Pretty cool, huh?

Just one caveat. Capital losses from the sale of any personal property are not deductible from gains. 

Something else to think about. If you are retiring, wait until you actually stop working to sell your second home. Your capital gains tax may be reduced if your retirement income is low enough. Between retirement and the two-year rule, you might not have to pay any capital gains taxes on that house.

Conclusion

Selling a second home doesn’t need to become a horrible tax burden due to capital gains. A lot depends on the price of the house, whether you established it as a primary residence, and your filing status.

With a bit of thought, you can reduce any capital gains taxes you may have upon selling any valuable asset. With a second home, you have an opportunity to turn it into a primary residence and thus be taxed differently. You can add the cost of improvements to the price of the home, reducing the profit you make. And, just like selling a primary residence, you can deduct the closing costs of the sale.

If you have more questions about the tax impact of selling a second home or other assets, contact Top Tax Defenders. Our experienced tax experts can help you get your taxes in order.