Calculating Your Capital Gains Tax
on The Sale of Your Vacation Home

Good Morning Relaxing Retirement Member,

A few weeks back, after walking three of our Relaxing Retirement members through the process of calculating the capital gains taxes they will owe when they sell their primary home, I shared the steps to take with you.

This triggered questions from some more members who inquired about any differences there might be 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 Cape Cod twenty eight 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 Cape house anymore.

You still enjoy spending time at the Cape, but the hassle of maintaining a four-bedroom home in addition to your primary home West 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 home twenty eight 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 a stock.  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 eight 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 $300,000 twenty eight 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 $400,000 ($300,000 purchase plus $100,000 in permanent improvements).

Now let’s assume that you sell your home for $800,000.  Assuming your realtor’s commission is 5%, $40,000 is taken off the top as a closing cost.  Assume for a moment that your other closing costs are $10,000 so you walk away from the sale with $750,000.

You then subtract $400,000 (adjusted cost basis) from the net sales price you received, or $750,000, and your capital gains tax due will be on $350,000.

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 $350,000 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 approximately $100,000.  Given all of this, after taxes, you would walk away with $650,000 after taxes and closing costs.

Two Exceptions

There are two 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 $800,000 thus negating any tax due.

The other 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 west of Boston and live in their Cape house for two years before selling it.  If they could do this, they would save the $100,000 capital gains tax.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach
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I appreciate the trust you place in me. Thank you! (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.)