Calculating Your Capital Gains Tax
on The Sale of Your Vacation Home
Good Morning Relaxing Retirement Subscriber,
Last week’s edition on calculating the capital gains tax due on the sale of your primary home triggered questions from some members about any differences if they sold a second home used for vacations.
This is a great question because there are big differences!
There are two separate situations depending on whether you rented out your second home or not. Let’s begin with the assumption that you did not rent out your second home.
Assume for a moment that you bought a second home on a lake in Maine twenty-five years ago when your family was younger and you were all able to spend large chunks of the summer enjoying it.
As time has passed, however, your family has spread out all over the country.
Your daughter and her family now live in North Carolina. One son now lives in San Francisco with his family, and your other son lives in Chicago.
While it’s wonderful that they’re all successful and independently supporting themselves and their families, it also means they rarely, if ever, take the opportunity to get down to your Maine house anymore.
You still enjoy spending time up in Maine, but the hassle of maintaining a four-bedroom home in addition to your primary home North of Boston is becoming too much to handle, especially with your desire to spend more and more time in warm weather down South during the winter months.
When you discuss the possibility of selling with your friends over dinner, the first topic they bring up is the capital gains tax you will have to pay when you sell the house. And, since you purchased the lake home twenty-five years ago, there is a lot of confusion over what you will owe.
How to Calculate
Selling a second home is similar to calculating the capital gain when selling any investment. The reason for this is you may not use the exclusions you use when selling your primary home.
As we outlined a few weeks back, when you sell your primary home, you may exclude $250,000 from the sales price if you are single, or $500,000 if you are married.
When selling a second home, there are no exclusions.
Given this, you will pay a capital gains tax on all sales proceeds over and above your cost basis.
Your cost basis equals the amount you paid for your home twenty-five years ago, plus any permanent improvements you may have made over all those years like an addition, or a new kitchen, or an irrigation system, etc.
And, you may also deduct closing costs which includes your realtor’s commission for selling your home.
Let’s assume that you paid $200,000 twenty-five years ago. The total amount of improvements you made to your home is $100,000. (A key strategy here is to document what you have paid in improvements over the years so you can show proof if subject to an IRS audit.)
Given all of this, your cost basis for the purposes of selling your home is $300,000 ($200,000 purchase plus $100,000 in permanent improvements).
Now let’s assume that you sell your home for $700,000. Assuming your realtor’s commission is 5%, so $35,000 is taken off the top as a closing cost. Assume for a moment that your other closing costs are $5,000 so you walk away from the sale with $660,000.
You then subtract $300,000 (adjusted cost basis) from the net sales price you received, or $660,000, and your capital gains tax due will be on $360,000.
Depending on how much other income you have, you will either be in the 15% or 20% federal capital gains tax bracket. And, in this case, because the $360,000 gain puts you over the medicare/Affordable Care Act threshold of $250,000, you also owe federal taxes of an additional 3.80%. (State taxes are in addition to this.)
Assuming for a moment that you are paying the 20% federal rate, your total capital gains tax (including state of Massachusetts) would be a little over $100,000. Given all of this, after taxes, you would walk away with approximately $560,000 after taxes and closing costs.
There are three exceptions to this which you must know about for proper planning.
First, if you pass away and your children sell your home as in the example above, no capital gains tax would be due. The reason for this is what is known as step-up in basis.
Similar to a sale of stock after death, your cost basis in the property is the value on the date of death. In this example, the stepped-up basis would be $700,000 thus negating any tax due.
The second exception is what is known as the two-in-five rule. If you make your second home your primary home for a while and you live there for two of the five years preceding the sale, you are able to utilize the $250,000/$500,000 exclusion you currently have available to you upon the sale of your primary home.
This is a terrific strategy if you can pull it off. What this couple could do is sell their primary home North of Boston and live in their home in Maine for two years before selling it. If they could do this, they would save the $100,000 capital gains tax.
Finally, if you rented your vacation home for any period of time, and thus you depreciated the value of your home for each year you rented it, thus receiving tax benefits each year along the way, the total amount you depreciated over the years reduces your cost basis dollar-for-dollar.
So, for example, if you rented it out for fifteen years and you were able take a depreciation deduction of $160,000 over the years, that $160,000 would reduce your cost basis from $300,000 down to $140,000, thus increasing the amount of capital gains taxes you would pay to approximately $46,000.
The bottom line is to keep careful records of all home improvements and prior deductions so you can accurately access your tax liability going in so there are no surprises.
Committed To Your Relaxing Retirement,
The Retirement Coach
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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)