Federal tax law imposes a capital gains tax whenever you sell an asset, such as your second home, and earn a profit. Since the IRS only allows you to exclude the capital gain on the sale of your main home, avoiding or reducing your tax liability on the second home depends on the capital losses you have available, your tax basis in the home and the holding period.
Taxes on Selling a Second House
The IRS requires you to report all capital asset sales, except for the sale of your main home in some cases, on a Schedule D attachment to your return. This obligates you to calculate the amount of gain you recognize on the sale using your tax basis. Your tax basis in a second home is equal to the price you pay to acquire or construct it, inclusive of most closing costs, plus the cost of all home improvements you make. Once you determine your tax basis, you calculate the capital gains on the sale of a second home as the sale proceeds minus your tax basis.
When you sell your second home at a gain, determining your holding period becomes extremely important. The holding period of capital assets refers to the length of time you own the property before selling it. For a second home that you own for one year or less, you must report it as a short-term capital gain. And for all other properties you own for more than one year, classify it as a long-term gain. This one-year period applies to capital gains tax on real estate and on other investments like stocks and bonds.
The significance of these two holding periods is that your short-term gains are subject to the same ordinary income tax rates that apply to most of the other income you report on your tax return. However, the capital gains rates, which are generally lower than ordinary rates, apply to your long-term gains.
The amount of tax you owe on the gain you report from the sale of your second home depends on the other capital assets you sell at a loss. This is because the IRS allows you to net your capital gains and losses together to reduce the amount of capital gains tax you will owe. Moreover, you can use the remaining capital loss balances from prior years as well as those you incur in the current year to reduce your capital gain on the second home.
In the unfortunate event you must sell your second home for less than your tax basis, you can at least use the loss to offset other current and future capital gains you generate. However, the IRS also allows you to claim a maximum annual capital loss deduction of $3,000 from your ordinary income (only $1,500 if you're married filing separately), but only if the second home is an investment property that you don’t use for personal purposes. Your second home qualifies as an investment if you purchase it to generate rental income or to recognize appreciation in its value. However, if you ever use it for personal purposes, such as for vacations, the annual deduction is not available.
Recapturing Previous Depreciation Deductions
Throughout your ownership of the property, you may have taken depreciation deductions, which allow a property owner to spread out the cost of the asset over time. If you later sell that property and realize a gain, you may have to recapture those deductions, i.e., the basis for the property is reduced by the depreciation. When that happens, the gain increases, resulting in a higher tax. Recaptured depreciation gains are taxed at 25 percent, while long term gains are taxed at a maximum of only 20 percent with many taxpayers paying a lower rate, so recaptured depreciation can increase your tax bill.
2018 Tax Law Changes
Long term capital gains tax on real estate and the surrounding laws are largely staying the same for 2018, but ordinary income tax rates are generally coming down for taxpayers under the new tax law. This will impact tax on a house sale that falls under short term gains or ordinary income.
2017 Tax Law
Ordinary income tax rates are generally higher for 2017 than they will be in subsequent years.
- IRS: Publication 551 -- Basis of Assets
- IRS: Publication 550 -- Investment Income and Expenses; January 2011
- IRS: Deducting Capital Losses
- IRS: Publication 946 -- How to Depreciate Property
- IRS: Tax Topic 409 -- Capital Gains and Losses
- Asset Preservation Inc: Impact of the 2018 Tax Law on Real Estate Owners
- Forbes: New: IRS Announces 2018 Tax Rates, Standard Deductions, Exemption Amounts And More