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Many real estate markets are still surging. That’s good news if you’re thinking about selling a vacation home that’s gone way up in value.
But what about the tax implications? Good question.
While the federal income tax gain exclusion break is still on the books, it’s only available for principal residences. Oddly enough, a vacation home will sometimes qualify for the gain exclusion break if you’ve also used the property as a principal residence. Good.
But a little-known rule might disallow part of the gain exclusion break that appears to be in the bag. Not good. This column explains the rather complicated federal income tax rules for gains from selling a vacation home. Here goes.
If the property was always used as a vacation home
In this scenario, the principal residence gain exclusion break is obviously unavailable. Your profit will be treated as a capital gain.
- If you’ve owned the property for more than one year and have never rented it out, and you have really high income, the effective federal income tax rate on your gain will be 23.8%: the 20% maximum capital gains rate plus another 3.8% for the net investment income tax (NIIT). However, many sellers will pay “only” 18.8%: the 15% capital gains rate plus 3.8% for the NIIT. You may owe state income tax too.
- If you’ve owned the property for more than one year and have rented it out, and you have really high income, the effective federal income tax rate on the “regular” part of your long-term gain will be 23.8%: the 20% maximum rate plus another 3.8% for the NIIT. However, many sellers will pay “only” 18.8%: 15% plus 3.8% for the NIIT. The maximum effective federal rate on gain attributable to depreciation deductions claimed during rental periods will be 28.8%: the 25% maximum rate on so-called unrecaptured Section 1250 gain from depreciation plus 3.8% for the NIIT. You may owe state income tax too.
Key Point: The preceding sounds pretty simple until you try to actually put it on the tax forms. Then it can get tricky. Hiring a pro to prepare your Form 1040 for the year of sale could be money well-spent.
If the property was also used as a principal residence
Here’s where it can get interesting. In a good way. You might be able to claim the tax-saving principal residence gain exclusion break, depending on your exact situation. Here’s how that could work.
Gain exclusion basics
Unmarried homeowners can potentially exclude principal residence gains up to $250,000, and married homeowners can potentially exclude up to $500,000.
Ownership and use tests
To take full advantage of the principal residence gain exclusion break, you must pass two tests: the ownership test and the use test.
- To pass the ownership test, you must have owned the property for at least two years out of the five-year period ending on the sale date.
- To pass the 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: (1) either you or your spouse pass the ownership test for the property and (2) both you and your spouse pass the use test.
As you can see, 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. So far, so good. But keep reading.
Anti-recycling rule
The other major qualification rule for the home sale gain exclusion break goes like this: 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 cannot recycle the gain exclusion privilege until two years have passed since you last used it.
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 one spouse claimed the exclusion within the two-year window, but the other spouse did not, the exclusion is limited to $250,000. Once again, so far, so good. But keep reading.
Taxes on profit that can’t be sheltered with gain exclusion
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 $250,000/$500,000 break. The part you cannot exclude is treated as capital gain with the tax results explained earlier.
While it seems like you qualify for the full gain exclusion deal, a little-known rule can reduce it
Once upon a time, you could convert a vacation home into a principal residence, occupy it for at least two years, sell it, and take full advantage of the $250,000/$500,000 gain exclusion privilege.
Unfortunately, a little-known rule can reduce the otherwise allowable gain exclusion for post-2008 sales. Let’s call the amount of gain that’s made ineligible the non-excludable gain. Calculate the non-excludable gain from your sale as follows.
Step 1: Take your total gain and subtract any gain from depreciation deductions claimed against the property for any rental periods after 5/6/97 (so-called unrecaptured Section 1250 gain). Report the gain from depreciation on Schedule D of Form 1040 for the year of sale. Carry the remaining gain to Step 3.
Step 2: Calculate the non-excludable gain fraction. The numerator is the amount of time after 2008 during which you did not use the property as a principal residence: so-called nonqualified use. Fortunately, nonqualified use does not include temporary absences that aggregate to two years or less due to changes of employment, health conditions, or other circumstances specified in IRS guidance. Nonqualified use also does not include times when the property was not 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. (See Example 2 below.)
The denominator of the fraction is your total ownership period for the property.
Step 3: Calculate the non-excludable gain by multiplying the gain from Step 1 by the non-excludable gain fraction from Step 2.
Step 4: Report on Schedule D of Form 1040 the non-excludable gain calculated in Step 3. As explained in Step 1, also report any unrecaptured Section 1250 gain from depreciation. The remaining gain after subtracting the nonexcludable gain and any unrecaptured Section 1250 gain is eligible for the principal residence gain exclusion privilege, assuming you meet the timing requirements.
Two examples
In my continuing efforts to reduce confusion resulting from ridiculously complicated federal income tax rules, I humbly present the following two examples that illustrate how to calculate non-excludable gains and excludable gains.
Example 1: You’re a married joint-filer. You bought a vacation home on 1/1/01. On 1/1/16, you converted the property into your principal residence and lived there with your spouse for 2016-2021. On 1/1/22, you sell the property for a $600,000 gain, including $50,000 of depreciation deductions claimed for the 15-year rental period (1/1/01-12/31/15).
You must report the $50,000 of gain attributable to depreciation deductions from periods when you rented the place while it was a vacation home (unrecaptured Section 1250 gain) on your 2021 Form 1040. That gain is subject to a maximum federal rate of 25% plus another 3.8% if the NIIT applies.
Your remaining gain is $550,000 ($600,000 – $50,000).
Your total ownership period is 21 years (2001-2021). The seven years of post-2008 use as a vacation home (2009-2015) result in a non-excludable gain of $183,333 (7/21 x $550,000). You must report the $183,333 as a long-term capital gain on Schedule D included with your 2022 Form 1040. You can shelter the remaining $366,667 of gain ($550,000 – $183,333) with your $500,000 joint-filer gain exclusion.
Example 2: You’re an unmarried person. You bought a vacation home on 1/1/13. On 1/1/16, you converted the property into your principal residence and lived there for 2016-2019. You then converted the home back into a vacation property and used it as such for 2020 and 2021 before selling the property on 1/1/22 for a $540,000 gain. Your total ownership period is nine years (2013-2021).
The first three years of post-2008 use as a vacation home (2013-2015) result in a non-excludable gain of $180,000 (3/9 x $540,000). You must report the $180,000 as long-term capital gain on Schedule D filed with your 2022 Form 1040. You can shelter $250,000 of the remaining $360,000 gain ($540,000 – $180,000) with your $250,000 gain exclusion. You must report the last $110,000 of gain ($540,000 – $180,000 – $250,000) as long-term capital gain on Schedule D filed with your 2022 Form 1040.
Complicated? You bet. Sorry about that.
Key point: The last two years of use of the property as a vacation home (2020-2021) don’t count as periods of nonqualified use because they occur: (1) after the last day of use as a principal residence (12/31/19) and (2) within the five-year period ending on the sale date (1/1/22). Therefore, your use of the property as a vacation home in 2020 and 2021 doesn’t make your non-excludable gain any bigger. Fair enough.
The bottom line
If you’ve always used a property as a vacation home, you won’t qualify for the gain exclusion break, and the tax results will be as explained at the beginning of this column.
By reducing your allowable gain exclusion break the unfavorable rule explained above can take some of the tax-saving fun out of converting a vacation home into a principal residence. That said, a reduced gain exclusion is better than no gain exclusion at al
Finally, converting a vacation home into a principal residence sooner rather than later can give you a better tax result, because it minimizes the period of nonqualified use that can reduce your allowable gain exclusion.
As you can see, this stuff is complicated. Don’t be ashamed to hire a tax pro to help you at tax return time.
