Selling Your Second Home without Paying Capital Gains Tax Takes Planning

As the most visited article on this blog, we can only assume that this is a hot topic in 2010. Please read this article carefully as it will answer all your questions about capital gains and your second home.  We specialize in facilitating Section 1031 exchanges, if you have questions regarding this topic, give us a call at 603-444-0020, we never charge for consulting.


It’s important to understand that there are two types of real property that can be sold with advantageous tax treatment.  The two types are personal use and business/investment use property.

Favorable treatment exists for the sale of a personal residence if the property has been the primary residence of the taxpayer for two of the preceding five years.  Section 121 of the Internal Revenue Code provides an exclusion from capital gains tax upon the sale of a primary residence of $250,000 per taxpayer or $500,000 for a married couple filing jointly.  An exclusion is the best treatment option and there is no requirement to reinvest the proceeds of sale in real property.  IRS Publication #523 provides complete guidance on a variety of scenarios and a few exceptions do exist for special circumstances if you cannot meet the two year rule.

Personal use property that has been used as a second or vacation home does NOT qualify for Section 121 exclusion from capital gains tax.  Upon the sale of a second or vacation home, it will NOT qualify for Section 1031 tax deferral either. The Internal Revenue Service issued guidance in 2008 that puts to rest the confusion of when personal use property does and does not qualify for exchange treatment.

Revenue Procedure 2008-16 establishes a safe harbor procedure for the sale of a vacation home that will qualify for Section 1031 treatment. Since you can only exchange property held for investment or use in a trade or business, personal use property, i.e.: vacation homes, is disallowed unless you can prove a change of use for two years prior to sale.

The revenue procedure clarifies that the dwelling unit (Relinquished Property) must be used by the taxpayer for 24 months immediately preceding the exchange and the new unit (Replacement Property) must be held for 24 months immediately following the exchange as business property.  The property must be rented to others for more than 14 calendar days in each of the 2 years preceding and the 2 years following the exchange to qualify for Section 1031 treatment.  Personal use by the owner or its relatives is limited to 14 calendar days or 10 percent of the days actually rented, whichever is greater, in the two twelve month periods before the exchange and for the following two twelve month periods after the new property has been acquired.

It is advisable to keep detailed records of personal use and not to exceed the limits. In short, tighten up your record keeping and the tax reporting of your property. Be serious in your rental attempts; charge your friends the going rental rate when they use it. Keep detailed records of the dates you use it and what you did – especially for each maintenance day.  Change in use is a legitimate way to avoid capital gains taxation; however, it requires that you play by the book!

The second type of property is investment property or property used as business or trade property by the taxpayer. It is always exchangeable regardless of whether it is rented to others or used by the taxpayer in its own business.  Section 1031 provides tax deferral if a Qualified Intermediary (QI) is engaged before the closing of the existing or Relinquished Property.  At closing the net proceeds are sequestered away from the taxpayer and directed to the QI to function as escrow agent. Full tax deferral of capital gain tax is achieved when the exchangor has gone even or up in value, used all of the cash in the qualified escrow account and replaced the debt given up on the Relinquished Property with new debt on the acquired Replacement Property. The Replacement Property must be properly identified within 45 days of the sale of the Relinquished Property and acquired by the 180th day.

It is possible to convert property from one type to another without tax consequences.  Your primary residence can become your rental/investment property and your investment/rental property can become your primary residence. How the property is used and accounted for the two years preceding and succeeding sale will determine the tax treatment.  Make a plan before the sale to “never pay the tax.”  Section 1031 is the conduit to wealth building, EXCHANGE to keep all your equity working for you!

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About John Hamrick

I am a Qualified Intermediary and educator at Edmund & Wheeler, Inc., a real estate services firm that specializes in the facilitation of Section 1031 exchanges and replacement property options. We have been facilitating exchanges for over 30 years. We are very well known by real estate professionals, accountants, lawyers, business brokers and financial planners as the go-to company for all things related to Section 1031.
This entry was posted in Second Homes, Section 1031 Basics, Section 121, Tax Advisories, Tax Reporting and tagged , , , , , . Bookmark the permalink.

21 Responses to Selling Your Second Home without Paying Capital Gains Tax Takes Planning

  1. AJay says:

    I put my home up for sale in 2012 but I took it off the market after about 5 months because I needed to some work on it. I bought another home in June 2012 and put the other home back on the market in early 2013. I was able to sell it in May 2013. Can I still use the 250,000 exemption even though I was no longer living in it? I lived in the home the previous 8 years (2004-2012) and have never used this exemption prior

  2. Donna says:

    We sold a rental house using the 1031 exchange to buy another house. We did not rent it, but used it as our vacation house. We now want to sell it ( at a loss), if we would rent for two years before selling, will we still be okay with the exchange rules, and even if not, will we be able to take the capital gain loss on taxes when we sell?

    • John Hamrick says:

      Hi Donna:

      Depending on what you deferred to buy the property, you may indeed be better off converting it to rental property for two years and then exchanging again. Even if you sell at a loss, you will still have to pay the capital gains you deferred when you purchased the property, the loss won’t offset the gains. Call me in the office if you would like to discuss. John Hamrick 603-3369-3190.

  3. ML says:

    My husband and I are in the process of selling our home of 8-years and buying property in New Mexico where we will be starting a 5-year plan to build an art studio, to live in temporarily while we build our larger off-the-grid home. We also have a home in a nearby college town that we had purchased 4-years ago for our four children to live in while going to college. Unfortunately, only one child went there and transferred out after three semesters and my husband’s brother has lived there the remainder of the time. We would like to sell this home as well, (will probably only make around $10,000) and are wanting to use the capital gains from both homes to buy the land and help finance our build. Since we are building and not outright buying a home, what would our tax implications be? And, would it be better to sell both properties now or stagger the sales?

  4. JOHNNA WOOD says:

    Are there any HARDSHIP SITUATIONS to a avoid capital gains when selling a second home?

  5. Skale says:

    My spouse owns a property overseas, and is thinking selling it. Obviously, this is not our primary house and we are wondering if she will have to pay capital gain and how much that would be… The property itself was given to her by her father some 10 years ago, and he used to live there until he passed away. Estimated value right now is 80,000 euros (about $108,000)…

    Thanks!

    • John Hamrick says:

      Hello, and thanks for your message. There will be capital gains exposure on the sale of this property. The exact amount will be determined by your tax basis and your current annual income. There may be foreign taxes as well. You can use Section 1031 for this sale, however, you must exchange for other foreign property. You can not exchange for property within the US. Call us at 603-444-0020 if you have any additional questions.

  6. Eric says:

    We tried to sell our home in 2010 but it didn’t sell so we have been renting it. We are under contract to sell the home almost three years to the day that we started renting the home. What are the implications on the money earned in the sale of the home?

    • Tim Burger says:

      Hi Eric,

      First off, congratulations on finding a buyer. The short answer is that upon closing you will owe tax on the gain unless you close in an exchange (and purchase other real estate within 180 days). Since you have been renting the home for three years and reporting the rental income on Sch E of your federal tax returns you should qualify for an exchange.

      If you would like to discuss in more detail, please give us a call (603) 444-0020. We love to answer questions.

      Tim

  7. John M. says:

    John,
    I am selling a second home (vacation home) and there will be a capital gain. Are there any tax protections if I use the gain to pay down the loan on my primary residence? What about if I reinvest the gain in another property?

    • John Hamrick says:

      Hello John:

      Second homes do not qualify for Section 1031 treatment. Second homes fall under the category of “Personal Use’ real estate. Unfortunately, even if you could exchange your second home (by first converting to a rental for 2 years) you could not use the proceeds to pay down the mortgage on property that you already own. We have many clients with second homes that are waiting out the two year period (as the rental requirements are not strict) to enable them to use 1031 to invest in other real estate, or passive income producing properties.

  8. Todd Seehafer says:

    Hi John,
    We bought a mobile home on a lakefront lot for a second home in 1999 and then later tore it down and built a home mostly ourselves and are asking 195.000.00. How much capital gain would we pay? We borrowed 140.000.00 for the mortgage and still owe 130.000.00.
    We did rent our lake home for six to nine weeks in the summer as income rental and claimed it on our taxes for the last 4 years. Thanks Todd Seehafer

  9. Tony says:

    George,
    A little over a year ago I turned my primary residence of twenty years into a rental so that I could purchase the house I currently live in. When would I have to pay capital gains on the rental should I decide to sell it. In other words, if I sold it within 2 years would I have to pay gains? 3 years, 4 years?

    Thanks for your reply.

    • John Hamrick says:

      Hi Tony:

      This is John Hamrick at Edmund & Wheeler. If you sell it within two years you can still get the Section 121 exemption. After a two year period of rental you can sell the property, use the exemption and still exclude up to $500K if married using Section 121. If your gains are over that amount, you could use a combination of Section 1031 and Section 121 and defer all taxes with an exchange. Please call me on my direct line at 603-336-3190 if you would like to discuss this. My email address is john@section1031.com. Thanks for contacting us.

  10. donna.ivey says:

    Hi my husband is 80 and I’m 61. We have owned a home in Maine since 1980. We became residents of Fl. In 1999. We have used our Maine home for vacations in the summer since then, anywheres from 4-6 months. We can no longer keep up both places so will put our Maine home up for sale next month. We paid $56000 in 1980 and hopetoget $150000. What will we have to pay in capital gains.

    • John Hamrick says:

      Hi Donna: Unfortunately since your home was used as your second home and not an investment property it will not qualify for Section 1031 treatment. You will have to pay regular capital gains rates upon sale. If you convert this property to an investment property for the next two years, it could then qualify for Section 1031 and you could do an exchange into income producing property without paying capital gains taxes.

  11. Bill says:

    can loss on sale of secondary residence be used as offset against gains on stock sale

    • John Hamrick says:

      Hi Bill, unless your secondary residence is an investment property (filed on Schedule E and with limited personal use) you will not be able to offset gains on your stock sale with a loss from your second home. Call me at 603-336-3190 if you have further questions.

  12. nice article I hope people plans on avoiding capital gains tax on selling your second home doesn’t change with whoever comes in office next. I talked to the people at http://sell-without-capital-gains-tax.com and they think it might

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