Mary Lou Schwab, retired CPA, has provided expert advice about saving money on vacation home tax or 1031 exchanges when you sell.
Owning a vacation home can be rewarding financially and emotionally. You might live in a Luxury Denver home but love your vacation house also whether it is in Vail or Arizona. Owning a vacation home can be a great experience. But, investors who have held vacation home for many years can face significant vacation home tax when they go to sell it.
Federal long term capital gain tax rates can be anywhere from 15 to 20%. The unearned income tax rate is 3.8%, and a depreciation recapture at 25% could be incurred. Additionally, state tax rates will also apply. Adding it all up, a potential tax liability upwards of around 39% can come as a rude surprise for most investors.
So what other options do investors have to limit or defer their tax liability? One option is to convert the use of the property into your primary residence. Another is to do a 1031 Exchange.
Option 1: The Primary Residence Option
The conversion of the property to a primary residence would not result in an immediate tax liability. Because, the property is not being sold. So, the investor could move into the vacation home, making it their primary residence for two years or more. Then, you can can prorate between the business rental use of the property and the primary residence use of the property.
In addition, vacation home tax rules require the investor to own the property for a total of five or more years before the property is sold. Also, the longer the converted property is held as a primary residence, the higher the peroration for the primary residence exclusion. That’s is up to $250,000 for an individual, and $500,000 for a married couple filing jointly.
Option 2: The 1031 Exchange Option
Or, you can use the 1031 Exchange as another method to defer vacation home tax. To avoid any possibility of a challenge to your vacation home exchange, your vacation property has to meet certain requirements. During the 24-month period preceding the sale of your vacation home, you must:
- Rent out the property, at fair market value, for at least 14 days in the 12-month period for two years or more (i.e.: rent it for a minimum of 14 days from July to June, then do it again), AND,
- Not use the property for your own personal vacation time for more than 14 days.
Whether you rent it to others for 14 days or 140 days, you still get your own personal 14 days of vacation use. Beyond this, there’s a 10% rule. That rule allows you to make more personal use days for yourself, family and friends, by just renting it out for more days. So, if you rent it for 150 days, tax rules allow 15 days of personal use.. If you rent it for 300 days, those same rules allow 30 days of personal use. That’s the 10% rule.
Personal Use of A Vacation Home Rental
Staying at your vacation rental home is not considered “personal use” if you’re engaged in repair, upkeep and annual maintenance on a substantially full time basis for any day. This means you can be in the house fixing stuff eight hours a day and call it a “maintenance day” if you document the repairs, time and materials used. However, document the repairs and improvements to show that actual work was done.
In summary, an owner can take their second home or vacation home and rent it for 14 days a year at fair market value for two years, then exchange out of it. After holding the new property for two years as a vacation home rental, you can then convert the use of the new property into your own primary residence. That’s how to save money on vacation home tax when you sell.
You can read more of my articles about taxes on vacation homes on my website. Or, I’d love answer any questions you might have. Just ask on this convenient form.