Tax Options for Vacation Home Owners Who Want to Sell

Get the Timing Right

The tax hit from selling a vacation home depends on the size of the taxable gain and your overall taxable income in the year of sale. If you've owned the property for more than one year and have never rented it out, you'll owe federal capital gains tax at the lower rates for long-term capital gains (LTCGs).

The current maximum rate for LTCGs is 20%. But you'll owe that rate only on the lesser of:

• Your net LTCGs, including any LTCG from the vacation home sale plus qualified dividends or
• The excess of your taxable income, including any net LTCG plus qualified dividends, over the applicable threshold.

Here are the thresholds for the maximum rate for 2025:

2025 Taxable Income Thresholds for 20% LTCG and Qualified Dividend Tax Rate

Most people will pay 15% on any net LTCG. You may also owe 3.8% for the net investment income tax (NIIT), if applicable. Taxpayers with modified adjusted gross income (MAGI) over $200,000 per year ($250,000 for married filing jointly and $125,000 for married filing separately) are subject to the NIIT on the lesser of their net LTCG plus qualified dividends or the amount by which their MAGI exceeds the applicable threshold. If you also owe the 3.8% NIIT, the effective federal rate on your net LTCG will be either 18.8% (15% plus 3.8%) or the maximum 23.8% (20% plus 3.8%). 

If possible, try to sell your appreciated vacation property in a year when you can avoid the maximum LTCG rate. For example, that could be a year when your income drops because you've retired or when you've harvested capital losses from investments held in taxable brokerage firm accounts. 

Option 1: Convert the Property into Your Principal Residence

One possible tax-smart option is to move into your vacation home. If you live there for at least two years before selling, the property can become your principal residence, potentially qualifying it for the federal income tax home sale gain exclusion.

This exclusion is one of the biggest personal tax breaks on the books. Eligible single taxpayers can exclude home sale gains up to $250,000 and eligible married joint-filing couples can exclude gains up to $500,000. Married people who file separately can potentially qualify for two separate $250,000 exclusions.

To be eligible for the home sale gain exclusion, you must pass the following two tests:

1. Ownership test. You must have owned the property for at least two years during the five-year period ending on the sale date.  
2. Use test. You must have used the property as your principal residence for at least two years during the same five-year period.

Important: To qualify for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test.

Beware, however, of a little-known rule that may reduce your allowable gain exclusion.

Computing Nonexcludable Gains on Vacation Homes

If you converted your vacation home into your principal residence, you might think you're in the clear for claiming the home sale gain exclusion. Not so fast! Part of the gain from selling the property may be ineligible for the exclusion under current tax law.

Follow these four steps to calculate the nonexcludable gain from the sale:

1. Compute the gain attributable to any depreciation deductions claimed against the property for any rental periods after May 6, 1997. This is referred to as the unrecaptured Section 1250 gain and it's taxed at a maximum federal rate of 25%. After subtracting any unrecaptured Sec. 1250 gain from the total gain, carry the remaining gain to the third step.
2. Calculate the nonexcludable gain fraction. The numerator is the period of time after 2008 during which the property wasn't used as your principal residence. The denominator is your total ownership period for the property.
3. Calculate the nonexcludable gain by multiplying the gain from the first step by the nonexcludable gain fraction calculated in the second step.
4. After subtracting any unrecaptured Sec. 1250 gain and the nonexcludable gain, the remaining gain is eligible for the principal residence gain exclusion privilege if you pass the ownership and use tests explained in the main article.

Important: If you have a significant overall gain, the remaining gain after making the two subtractions in the fourth step could be big enough to take full advantage of the home sale gain exclusion. Your tax advisor can help you crunch the numbers correctly.

Option 2: Leverage a Tax-Favored Section 1031 Exchange

Another tax-smart strategy is to arrange a Section 1031 (like-kind) exchange. This option is available only for properties used for business or rental purposes. So, if you haven't been renting your vacation home, you'll first need to convert it to what qualifies as a rental property under the tax law.

When available, a Sec. 1031 exchange allows you to unload an appreciated property (the "relinquished" property) and acquire another one (the "replacement" property) without triggering a current federal income tax bill on the relinquished property's appreciation. The gain is rolled over into the replacement property, where the gain is deferred until you sell the replacement property in a taxable transaction.

What happens if you still own the replacement property when you die? Under current federal income tax rules, the tax basis of a deceased person's share of the property is "stepped up" to its date-of-death value. In that situation, your share of any taxable gain accrued during your lifetime would be completely washed away.

The IRS established a "safe harbor" that allows tax-deferred Sec. 1031 exchange treatment for swaps of vacation properties, including "mixed-use" vacation homes that you've rented out part-time and used personally part-time. To be eligible, both the relinquished and replacement properties must meet the safe-harbor requirements.

Specifically, the relinquished property must pass two tests:

• You must have owned it for at least 24 months immediately before the exchange.
• Within each of the two 12-month periods during the 24 months immediately before the exchange: 1) you must have rented out the property at market rates for at least 14 days and 2) your personal use of the property can't have exceeded the greater of 14 days or 10% of the days the property was rented out at market rates.

In addition, the replacement property, which can be virtually any kind of real estate, must pass two tests:

• You must continue to own it for at least 24 months after the exchange and you must hold it for rental or business purposes.
• If the replacement property is another vacation home, within each of the two 12-month periods during the 24 months immediately after the exchange: 1) you must rent out the property at market rates for at least 14 days and 2) your personal use of the property can't exceed the greater of 14 days or 10% of the days the property is rented out at market rates.

Executing this strategy is complicated. Consult your SSB tax advisor for the details.

Option 3: Hold the Property

Sometimes, doing nothing might actually be the best move. Holding on to your vacation property until you pass away could be a tax-smart choice because of the step-up in basis rule. When you die, the tax basis of your share of the property is adjusted to its fair market value at the time of your death, eliminating your share of any taxable gain that accrued during your lifetime.

If your heirs subsequently sell the property, they'll be taxed only on any post-death appreciation. However, if you and your spouse co-own the property, the basis step-up rule can be tricky. Consult your SSB tax advisor for full details on how it works in that scenario.

It's Not All About Taxes

While taxes are important, they shouldn't be the only factor in your decision. Vacation homes often carry strong emotional significance. The right strategy depends on various factors such as:

• Your age and health,
• Family members' emotional ties to the property and
• Your financial situation and long-term goals.

For instance, the considerations for a retired couple may differ from those of a young couple with busy young kids. Consult your SSB tax, SSB financial and legal advisors to discuss what's right for your situation.

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