The Trick To Avoid Paying Capital Gains Tax on Your Second Home

When you bought your second home you likely had a vision for it. Your vacation home was meant to be a place of relaxation, your rental property, an investment. 

But if you don’t have an estate plan in place, the dream you had for your second home could turn into a tax nightmare when you sell it.

That’s because these assets are subject to capital gains taxes, a tax of up to 20% (and in rare cases, 25%) that can be complicated to navigate for the uninitiated. Luckily, workarounds exist for the savvy estate holder.

What is capital gains tax?

When you sell a capital asset—whether it’s an artwork, stock or bonds, a second home, or similar – the difference between what you bought the asset for and what you sell it for is a capital gain (if you make money) or loss (if you lose money). The IRS levies a special tax rate on capital gains, ranging from 0% to 20%, or higher in some unique instances.

The primary residence tax exemption

Luckily, homes get a special exception from this rule, thanks to the Tax Payer Relief Act of 1997. Under the provisions in this law, you can sell a primary residence and exclude up to $250,000 of capital gains from taxes if you file as a single taxpayer, or up to $500,000 if you're married and file jointly—and there are generous terms for deducting the cost of any home improvements to lower your tax burden further.

But if your home isn’t your primary residence—be it your vacation home, a rental property, or investment property—you should be prepared to pay capital gains tax when you sell. How much you pay will depend on several factors.

How is capital gains tax calculated?

Capital gains taxes are levied only on the net gain you make from your sale. For example, if you bought your second home for $300,000 and sold it for $500,000, you’d net $200,000 on the sale—and only that amount (not the full $500,000 sale price) would be subject to a capital gains tax.

But the rate at which your gains are taxed depends on two factors: how long you’ve owned the asset and your income.

Short-term capital gain

If you’ve owned an asset for one year or less before you sell it, it’s considered a short-term capital asset and is taxed according to your ordinary income tax bracket. This rule does not apply to gifts, inherited property, or patents.

Long-term capital gain

If you’ve owned an asset for a year or longer before selling it, you’ll be taxed at a long-term capital gains rate, which is typically lower than your income tax rate. These rates vary based on your income, ranging from 0% to 20%.

How to avoid paying capital gains tax on your second home

Reducing your capital gains burden requires planning. Here are three of the most common ways to avoid it:

1031 exchange

By utilizing a 1031 exchange, investment property owners defer paying capital gains taxes by reinvesting the proceeds from a property sale into a new investment property. This allows investors to preserve their capital and grow their portfolio without an immediate tax burden.

“It’s a great tool to delay taxes and eventually avoid them all together if the replacement property is held long enough” says Jacqueline Salcines, a practicing real estate lawyer with over 26 years of experience.

For example, say you purchased an investment property for $750,000 and later sold it for $1 million, you’d typically owe capital gains on the $250,000 profit. However, if you use a 1031 exchange, you could reinvest your gain to purchase a new investment property and postpone your tax liability.

That said, a 1031 exchange comes with strict requirements. They can only be used for investment properties, not personal residences. However, if you first turn your second home into a business property by renting it out before selling, you may be able to qualify for a 1031 exchange.

Rent out the home

With rental prices still well above their pre-pandemic benchmarks, you might have more to gain from not selling at all and turning your second home into a rental property. If your second home is in a coveted vacation spot, for example, consider turning it into a short-term rental. This booming business can net you enough to cover operating expenses and then some.

But if you don’t want to deal with the management short-term rentals require, long-term rentals are also a solid option. Just be ready to fix a leaky garbage disposal or patch a nail hole when your tenant moves.

Make your second home your primary residence

If you’ve lived in your home for at least two of the past five years, it may qualify as your primary residence, making you eligible for a significant capital gains tax exclusion when you sell. This can be a smart tax strategy if you’re considering selling a second home in the next few years—and moving in now could help you take advantage of this benefit.

However, if you’re married and filing jointly, both spouses must meet the residency requirement, even if only one spouse owns the property. This exclusion also has a limit: You're not eligible if you've already claimed it in the past two years.