Many real estate markets are still booming. This is good news if you are thinking about selling a vacation home that has grown in value significantly.
But what about the tax implications? Good question.
While the federal income gains exclusion is still in effect, it is only available for primary residences. Oddly enough, a vacation home will sometimes qualify for the exclusion of earnings clause if you’ve also used the property as your primary residence. Good.
But a little-known rule could prohibit some of the break-out winnings that appear to be in the sack. Not good. This column explains the rather complicated federal tax rules for earnings from the sale of a vacation home. Here is.
If the property has always been used as a holiday home
In this scenario, the exclusion break of the gain of principal residence is obviously not available. Your profit will be treated as a capital gain.
If you have owned the property for more than a year and have never rented it out and have very high incomes, the effective federal tax rate on your gain will be 23.8%: the maximum rate of 20% of capital gains plus 3.8 more. % for the tax on net investment income (NIIT). However, many sellers will pay “only” 18.8%: the 15% capital gains rate plus 3.8% for the NIIT. You may also owe state income tax.
If you have owned the property for more than a year and rented it out and have very high incomes, the effective federal tax rate on the “ordinary” part of your long-term gain will be 23 , 8%: the 20% maximum rate plus 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 gains attributable to depreciation deductions claimed during rental periods will be 28.8%: the maximum rate of 25% on so-called unrecovered depreciation gains in section 1250 plus 3.8% for the NIIT. You may also owe state income tax.
Key point: The above sounds pretty straightforward until you try to put it on tax forms. Then it can get tricky. Hiring a pro to prepare your Form 1040 for the sales year could be money well spent.
If the property also served as a main residence
Here’s where it can get interesting. In the right direction. Depending on your exact situation, you may be able to apply for the tax exemption for the gain of a principal residence. Here is how it might work.
Acquire the basics of exclusion
Unmarried owners can potentially exclude primary residence earnings up to $ 250,000, and married owners can potentially exclude up to $ 500,000.
Ownership and use tests
To take full advantage of the disqualification from gaining a principal residence, you must pass two tests: the property 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 date of sale.
To pass the use test, you must have used the property as your primary residence for at least two years out of the five-year period ending on the date of sale.
If you are married and filing jointly, you are eligible for the higher exclusion of $ 500,000 if: (1) you or your spouse pass the property ownership test and (2) you and your spouse pass the property test. use.
As you can see, there is a chance that you will pass these tests for a property that has been used both as a vacation home and as a primary residence. So far, so good. But read on.
The other major qualifying rule for the Home Sale Gain Exclusion Breakdown is this: The exclusion is generally only available when you have not ruled out a prior gain in the period of two years ending on the date of the subsequent sale. In other words, you generally can’t recycle the Earnings Exclusion Privilege until two years have passed since you last used it.
You can only apply for the larger $ 500,000 joint filer exclusion if neither you nor your spouse benefited from an early sale within the two-year period. If one spouse requested the exclusion within the two-year window, but the other spouse did not, the exclusion is limited to $ 250,000. Again, so far everything is fine. But read on.
Income taxes which cannot be sheltered with exclusion of earnings
If you make a big profit selling a vacation home, it may be too large to be fully protected with the gain exclusion, even though you qualify for the maximum break of $ 250,000 / $ 500,000. The part that you cannot exclude is treated as a capital gain with the tax results explained above.
While it looks like you qualify for the Full Earning Exclusion Agreement, a little-known rule may narrow it down.
Once upon a time, you could convert a vacation home into a primary residence, occupy it for at least two years, sell it, and take full advantage of the $ 250,000 / $ 500,000 exclusion of earnings privilege.
Unfortunately, a little-known rule can reduce the otherwise eligible gain exclusion for sales after 2008. Let us call the amount of the gain that is 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 the depreciation deductions claimed on the property for any rental period after 6/5/97 (this is called the section 1250 unrecovered gain). Report the depreciation gain on Schedule D of Form 1040 for the year of sale. Carry over the remaining gain in step 3.
2nd step: Calculate the fraction of non-excludable gain. The numerator is the period after 2008 that you did not use the property as your principal residence: this is called non-qualifying use. Fortunately, unskilled use does not include temporary absences that total two years or less due to job changes, health conditions, or other circumstances specified in IRS guidelines. Non-qualifying use also does not include periods when the property was not used as a primary residence if those periods are: (1) after the last day of use as a primary residence and (2) at during the five-year period ending on the date of sale. (See example 2 below.)
The denominator of the fraction is your period of total ownership of the property.
Step 3: Calculate the non-excludable gain by multiplying the gain from step 1 by the fraction of the non-excludable gain 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 unrecovered gain in Section 1250 from depreciation. The gain remaining after subtracting the non-excludable gain and any unrecovered Section 1250 gain qualifies for the principal residence gain exclusion privilege, assuming you meet the schedule conditions.
In my ongoing efforts to reduce the confusion resulting from the ridiculously complicated federal tax rules, I humbly present the following two examples which illustrate how to calculate non-excluded earnings and excluded earnings.
Example 1: You are a married spouse filer. You bought a holiday home on 01/01/01. On 1/1/16, you converted the property into your primary residence and lived there with your spouse for 2016-2021. On 1/1/22, you sell the property for a gain of $ 600,000 including $ 50,000 in depreciation deductions claimed for the 15 year rental period (1/1 / 01-12 / 31/15) .
You must report the $ 50,000 gain attributable to depreciation deductions for the periods you rented the place while it was a vacation home (unrecovered gain from section 1250) on your 2021 form. 1040. This gain is subject to a maximum federal rate of 25% plus another 3.8% if the NIIT applies.
Your remaining payout is 550,000 ($ 600,000 – $ 50,000).
Your total ownership period is 21 years (2001-2021). The seven years of use as a second home after 2008 (2009-2015) translates into a non-exclusive gain of $ 183,333 (7/21 x $ 550,000). You must report the $ 183,333 as long-term capital gain on Schedule D included with your 2022 1040 form. You can shelter the remaining $ 366,667 ($ 550,000 – $ 183,333 ) with your $ 500,000 earning exclusion for co-filers.
Example 2: You are a single person. You bought a holiday home on 01/01/13. On 1/1/16, you converted the property into your primary residence and lived there for 2016-2019. You then converted the home back to a vacation property and used it as such for 2020 and 2021 before selling the property on 1/1/22 for a gain of $ 540,000. Your total ownership period is nine years (2013-2021).
The first three years of use as a second home after 2008 (2013-2015) result in a non-exclusive gain of $ 180,000 (3/9 x $ 540,000). You have to report the $ 180,000 as a long-term capital gain on Schedule D filed with your Form 2022 1040. You can put $ 250,000 of the remaining gain of $ 360,000 ($ 540,000 – $ 180,000) safe with your exclusion of $ 250,000 for gain. You must report the last $ 110,000 of gain ($ 540,000 – $ 180,000 – $ 250,000) as a long-term capital gain on Schedule D filed with your Form 2022 1040.
Complicated? You bet. Sorry about that.
Key point: The last two years of use of the property as a secondary residence (2020-2021) do not count as periods of unqualified use because they occur: (1) after the last day of use as a primary residence (31 / 12/19)) and (2) within the five-year period ending on the date of the sale (1/1/22). Therefore, your use of the property as a vacation home in 2020 and 2021 does not increase your non-exclusive gain. Fair enough.
The bottom line
If you have always used a property as a vacation home, you will not be eligible for the Earnings Exclusion Reduction and the tax results will be as explained at the start of this column.
By reducing your offense to the allowable earnings exclusion, the adverse rule explained above may reduce some of the fun of saving tax on converting a vacation home to a primary residence. That said, a reduced gain exclusion is better than no gain exclusion at al.
Finally, converting a vacation home to a primary residence as soon as possible can give you a better tax result, as it minimizes the period of ineligible use which can reduce your exclusion from qualifying earnings.
As you can see, this stuff is complicated. Don’t be ashamed to hire a tax professional to help you with your tax return.