What if you convert a vacation home to your primary residence, live there for at least two years and then sell it? Can you qualify for the full $250,000/$500,000 capital gains tax exclusion? No.
If you sell a main home that you previously used as a vacation home, some or all of the gain is ineligible for the home-sale exclusion. The portion of the gain that is taxed is based on the ratio of the period of time after 2008 that the home was used as a second residence or rented out to the total time that the seller owned the house. The remaining gain is eligible for the $250,000 or $500,000 home-sale exclusion.
If you hold rental property, the gain or loss when you sell is generally characterized as a capital gain or loss. If held for more than one year, it’s long-term capital gain or loss, and if held for one year or less, it’s short-term capital gain or loss. The gain or loss is the difference between the amount realized on the sale and your tax basis in the property.
The capital gain will generally be taxed at 0%, 15% or 20%, plus the 3.8% surtax for people with higher incomes. However, a special rule applies to gain on the sale of rental property for which you took depreciation deductions. When depreciable real property held for more than one year is sold at a gain, the rule requires that previously deducted depreciation be recaptured into income and taxed at a top rate of 25%. It’s known as unrecaptured Section 1250 gain, the number of its own federal tax code section.
Take this simple example: You bought a rental home for $300,000, deducted $109,000 of depreciation and sold the property for $500,000 this year. The first $109,000 of your $200,000 gain is unrecaptured Section 1250 gain that is taxed at a maximum rate of 25%, while the remaining $91,000 is taxed at the regular long-term capital gains tax rates.
Note that the unrecaptured Section 1250 gain can also apply to the sale of your main residence if you took depreciation deductions for it in the past, such as from a conversion from a rental home to your primary home or if you had an office in the home.
Capital losses from the sale of rental real estate can offset your capital gains, plus up to $3,000 of other income.
When real property used in a business or held for investment is exchanged for like-kind real property under Section 1031 of the tax code, all or part of the gain that would otherwise be triggered if the realty were sold can be deferred. This tax break doesn’t apply to main homes or vacation homes, but it can apply to rental real estate that you own.
The rules are very complicated and tricky, with many requirements to meet. Also, President Biden and Congress have proposed rules to limit the break. Make sure to talk to your tax adviser if you’re contemplating a like-kind swap.
See eight examples of the capital-gains tax when selling a home here: