Avoid These Tax Surprises When Selling a Vacation Home

(Image credit: Getty Images)

published 21 July 2024

When Amiee LaMont and her husband Ray Struble sold their rental house in Fairfax, Va., they got a six-figure surprise from their accountant. “We got a good-sized tax bill,” LaMont says.

And how: They paid about $172,000, she says.

Given the red-hot real estate market, you, too, could have a big tax on your gains when you sell. If you’re thinking about selling your second home, be sure to hold back some of your profits when tax time rolls around.

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The median existing U.S. home price — half higher, half lower — was $385,300 in the first quarter of 2024, up 21.2% the past three years. Prices in some popular vacation areas have soared even more. The median home price in Naples, Fla., for example, is up 41.7%, to $850,000 in three years. In the San Diego area, the median price is up 28.5%, to $981,000.

That’s good news for homeowners — although high prices can produce big tax surprises. The type of tax surprise you get depends, in part, on how you’ve used your second home. If you or a family member have lived in it 14 days or fewer per year and gotten a fair market rent from it, you have a rental property. If you’ve frolicked on the beach in front of your home for more than two weeks, it’s a vacation home.

This brings us to our first tax surprise.

Surprise 1: Tax breaks

When you sell your primary residence, you get a huge tax break. Couples filing a joint return can exclude $500,000 of the gain from taxes, while single filers can exclude $250,000.

You don’t get that tax break for a vacation home. You’ll pay federal and state capital gains taxes on your entire profit. (If the home is in another state, you may wind up paying taxes in both states.) The same is true for a rental property.

Federal capital gains tax ranges from zero to 20%. High earners — single filers with modified adjusted gross income (MAGI) of $200,000 and $250,000 for couples filing jointly — could end up paying an additional 3.8% Medicare surcharge.

Let’s say that you bought your vacation home for $250,000 and sold it 10 years later for $850,000. You owe capital gains taxes on your $600,000 gain. Uncle Sam’s 20% cut would be $120,000. Ow.

Flippers, beware: These are long-term capital gains rates, which only apply if you’ve owned the property for more than a year. If you’ve owned your property for less than a year, your gain will be taxed as ordinary income, which can be as high as 37%.

Surprise 2: Deductions

You’ll need some records from the entire time you owned the house. Why? Because you can deduct the cost of major improvements you’ve made over the years.

“Things have to be general improvements, a new kitchen, bathroom, things like that,” says Michael Hansen, a certified financial planner in Walnut Creek, Calif. To get those deductions, you’ll need to document your improvements. Otherwise, the IRS could disallow your deduction.

It's worth the hassle. Let’s look at that vacation home you bought for $250,000 and sold for $850,000. Let’s say you had built a $40,000 addition and replaced the roof for $20,000. You can add those costs to your cost basis, which will reduce your capital gains tax. In this case, your cost basis would rise by $60,000, from $250,000 to $310,000 — and that, in turn, would lower your tax bill to $108,000.

Surprise 3: Depreciation

If you have rented your vacation home, you can typically get an annual deduction for depreciation — basically, wear and tear on the building. Real estate is depreciated over 27.5 years. This applies only to dwellings, not land. If you paid $250,000 for just the house, you’d get a deduction for $9,091 a year for the time you’ve owned it, up to 27.5 years. Not bad, right?

It's not bad, that is, until you sell it. You’ll have to pay income taxes on your depreciation (capped at 25%) when you sell. So, if you claimed $50,000 of depreciation over the years, you’d pay ordinary income tax, up to 25%, on $50,000

Surprise 4: Medicare impacts

A big gain on your real estate could make your Medicare part B premium and your Medicare Part D prescription drug premium much larger, thanks to the income related monthly adjustment amount (IRMAA).

Your IRMAA payment depends on your income, and the higher the income, the higher your Medicare Part B and Part D payment, says Nicholas Bunio, a financial planner in Downingtown, Penn., who says profit from your home sale will be included in your income calculation for purposes of IRMAA. So, you’ll not only have more income from the sale of the house, but you’ll also likely have higher Medicare premiums.

A peculiarity of IRMAA is that it looks back at your returns from two years ago, not your current income. Here's an example for the 2024 tax year. Suppose you’re 65, filing singly, and have $100,000 in income.

Had you sold your vacation home in 2022 for a $600,000 profit, however, your IRMAA would tack on $419.30 a month to your Medicare Part B payment, and an additional charge of $81 on your Part D premium. Both premiums are deducted from your Social Security check. Fortunately, the payment is adjusted each year depending on your income two years prior, so you probably won’t have to pay the surcharge in the 2025 tax year.

How to reduce your tax liability

No one likes paying taxes, and there are few ways to escape the capital gains tax on your vacation home. You can defer or reduce them, however.

For example, if you were thinking about downsizing, consider moving into your vacation home and selling your current house. If you live in your vacation home for two years out of five, you’ll get the same tax breaks you’d get if you sold your primary home.

If you have a rental property, you might consider a 1031 exchange, which lets you swap properties tax-free with someone who has a property of about the same price. This will let you sidestep the tax on your current home gains and defer them to the future.

The drawback: You must keep your new property for at least two years. Otherwise, you may be liable for the capital gains tax you were trying to sidestep. You’re just deferring taxes, not eliminating them. And, if part of your decision to sell your property is because you were tired of fixing the plumbing and chasing raccoons out of its attic, owning another property through a 1031 exchange won’t necessarily help.

Although paying a honking big tax bill is no fun, in most cases you’ll still have a pretty large chunk of change after you sell your vacation home. And you won’t have to spend any more time evicting deadbeat renters (or raccoons) from your vacation home. Just make sure that you’re prepared for a bit of a shock at tax time.

Note: This item first appeared in Kiplinger Retirement Report, our popular monthly periodical that covers key concerns of affluent older Americans who are retired or preparing for retirement. Subscribe for retirement advice that’s right on the money.

John Waggoner has put personal finance and investing into plain English for more than three decades. He was a senior columnist for InvestmentNews and, prior to that, USA TODAY's personal finance columnist for 25 years. He has written for Morningstar, The Wall Street Journal, and Money magazine. Waggoner has also written three books on finance and investing. He has an undergraduate and graduate degree in English literature and is working on his Certified Financial Planner designation. He lives in Vienna, Virginia.