Second home vs investment property: IRS tax rules. If a property was used as both over time, what are the tax implications when the property is sold?

Q: I read your article on avoiding capital gains tax on second homes in our Sunday paper. I have a question that is along those same lines, except it’s a little more complicated. 

My wife and I bought a condominium in Florida in 1985 as an investment rental property. We rented it out for about 10 years, taking the allowable depreciation each year on our tax returns. In 1995, we decided to take it off the rental market and use it as our vacation home, which we have done for the last 25 years. 

What are the tax ramifications if we sell the property? Are we covered by the investment property tax rules or the vacation home rules? Are the improvements we made during the rental period handled differently than during the vacation home period? Do we need to know the value of the condo at the time we made the switch? 

Second Home vs Investment Property: IRS Tax Rules

Tax Implications When Selling an Investment Property

A: We’re going to break your questions into pieces and try to provide you with some direction.

The first question relates to your ownership of an investment piece of real estate. When you own a rental property, it’s an investment for you. The rental money is income to you and your expenses are deductible business expenses. An additional benefit of owning an investment property is your ability to depreciate the value of the improvements over a period of time — up to 37.5 years.

Likewise, when you sell that rental property, the IRS will expect you to pay taxes on any profit you have on the sale and to recapture any depreciation benefits you took while you owned the property. 

Although we understand you haven’t listed the property yet, let’s assume you actually sold your rental property last year and had a profit of $100,000 and that you took $100,000 in depreciation over the time you owned the property. In this example, you’d owe up to $20,000 in federal capital gains taxes on the sale of the investment and about $25,000 in recapture taxes. You’ll also owe 3.8% in taxes on investment income. Depending on the state you live in, you might owe state taxes as well.

Tax Implications When Selling a Second Home

The second part of your question relates to your ownership of a second home. You can rent or use your second home (or both). The amount of time each year it was rented may have a different impact on your tax return. If you primarily rented out the second home and used it less than 15 days per year personally, the home might still be your rental investment property.

But, if you use it most of the year and only rent it out a couple of days per year, or if you no longer rent out the property, the home may no longer be considered an investment property. Then, it would be a vacation or second home. 

Generally, when you sell a second home that has been generally used as your residence, you have to pay tax on the capital gains on the sale. You’ll pay up to 20 percent capital gains tax on the profit and you’ll pay the 3.8 percent tax on investment income. 

Over the years you probably put money into the home to renovate it and make capital improvements. You’ll have to determine what renovation costs and capital improvements would increase your basis in the home. (Generally, the IRS uses the term “basis” as what the property cost you including all closing costs and allowable capital improvements.)

We suspect that you’ll have to compute what you paid for the home, what allowable tax improvements you’ve made to the home and what other allowable costs can be included in determining your basis for the home. Once you have that number, you’ll probably end up having to pay tax on the profit (or gain) on the sale of the home on the basis of up to 20 percent capital gains tax and the 25 percent recapture tax on the depreciation you took while you owned the home. And, don’t forget the 3.8 percent tax on investment income.

IRS Resources to Determine Tax Liability When Selling a Home 

You’ll probably want to review IRS Publication 527 on residential rental property including the rental of a vacation home. The publication has examples and worksheets that might help get you started in the process of figuring out what your tax liability will be when you sell the home. Given the nature of real estate and the Covid-19 issues, we don’t know where you stand on the profit side of selling this home. 

You have owned the property for 35 years. In some parts of the country we can foresee that your sale could result in a huge profit to you while in others, the real estate market might not have been as kind. This is true even in Florida, where some coastal communities have seen huge gains in market value compared with other areas of the state. 

We hope you’re in the former and are looking forward to enjoying the fruits of your investment labors. But we suggest you talk with your tax preparer, enrolled agent or accountant sooner rather than later. Go over the details of your transaction and where you expect to wind up financially when you close. Your tax pros will then be able to share what your potential tax liabilities might be and what options you should consider to lessen any tax burden.

More on Topics Related to Second Home vs Investment Property: IRS Tax Rules

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