Avoiding Capital Gains Tax On Second Home

Added August 15, 2007 by Ilyce R. Glink

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Summary: How can you avoid capital gains tax? If you have a second home that you have been renting, you might face a large capital gains tax, especially if you have been taking depreciation on the investment property. The IRS has very specific requirements for how to handle primary and secondary property. You may be able to use a 1031 exchange if you move back into the rental property for two years.

Q: My husband and I have lived in one house and have had a second house that we have rented since we bought it in 1989 for $130,000. It now has a market value of $450,000.

If you factor in the depreciation we have taken over the years, we'll have a large capital gains tax to pay if we were to sell it.

Can we move to this house for two years, make it our primary residence and so qualify for the $500,000 tax break when we do sell? Would we be able to use the tax exclusion to sell our primary house that would then be an investment property?

A: Congratulations on making two savvy real estate investments. Yes, you and your husband can move back into your rental property for two years and then become eligible to keep the profits tax-free up to $500,000.

However, since you depreciated the property, you will have to pay back at least some of the depreciation on the property to the IRS. This will eat a bit into your profits, but you should still receive a healthy check at the closing and will have avoided capital gains taxes.

Two years after the sale of your home, you can sell the rental property that was formerly your primary residence and keep another $500,000 in profits tax free. The IRS only allows you to use this exclusion once every 24 months.

Please talk to your accountant for more details.

Published: Aug. 15, 2007

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