Once you have successfully negotiated the purchase of your first home, it’s easy to dream of owning a second home. Maybe you’ll buy it in your favorite vacation spot and own your little slice of paradise there. Or you can treat it as an investment property that you rent out. Ideally, you can do both rent it out part of the year, and then use it as your “home away from home” when you vacation. However, there may come a time when you find it necessary or desirable to sell that second home. When that happens, you may count on those profits to fund another dream: retirement, college for the kids, travel. Unfortunately, not all of those profits will be yours to keep. The IRS will ask for its share through the capital gains tax.
Capital Gains Tax
When you sell property at a profit, the IRS considers that profit to be part of your taxable income. A capital gains tax is levied on any profit (gain) that you made due to the appreciation of the property you sold.
For example, if you bought a $300,000 home, and later sell it for $400,000, your taxable capital gain on that transaction is the $100,000 profit. That is the amount that the IRS will tax.
Just like with income tax, the capital gains tax is not a flat fee. Rather, it is a percentage of the profit. The percentage will change based on your tax bracket. Some states also have their own state capital gains tax.
Selling a Primary Residence Vs. Selling a Second Home
If the property you sold is your primary residence, you will most likely pay very little or no tax. That is because the IRS has primary residence exclusion for capital gains taxes. If you are single, you can exclude as much as $250,000 in profit from the sale of your primary residence. If you’re married and filing jointly, that amount is $500,000. However, a second home, whether it is a vacation home or rental property, is not excluded. Here, you’ll have to pay a capital gains tax on the sale of your second home. Depending on how long you’ve owned your second home, your taxes will be a short-term capital gains tax or a long-term capital gains tax.
Short Term Capital Gains Tax
If you sell an investment property that you have owned for less than a year, it will be subject to the short-term capital gains tax. It will be taxed at the same rate as the rest of your annual income. Depending on your tax bracket, this can be as high as 37% of the gains.
Long Term Capital Gains Tax
On the other hand, if you are selling a second home that you have owned for over a year, the capital gains tax will be lower than your income tax bracket. Long term capital gains in 2021 are taxed at 0%, 15%, or 20%, depending on your income.
2021 Long Term Capital Gains Tax Rates Per Bracket
Your long-term capital gains tax rate will depend on both your income and filing status.
• 0%: if you are single and made under $40,400 OR are married filing jointly and made under $80,800 OR are the head of the household and made under $54,100.
• 15%: if you are single and made between $40,400 and $445,800 OR are married filing jointly and made between $80,800 and $501,600 OR are the head of the household and made between $54,100 and $473,750
• 20%: if you are single and made over $445,800 OR are married filing jointly and made over $501,600 OR are the head of the household and made over $473,750
Minimize Your Net Profit
If you bought your second home for $200,000 and sold it for $300,000, then your taxable capital gain is $100,000, right? Not necessarily! The key here is that the capital gains tax on the sale of the second home applies to the net profit, not the difference in purchase price and sale price. Any money you invested to renovate or repair your second home can be deducted from the profit. If you put in a new roof for $10,000, then your taxable gain is down to $90,000.
You can also deduct costs associated with the purchase and sale of your second home. Realtor commissions, inspections, origination fees, etc. Say you spent $5,000 in acquisition fees to purchase the home, and paid $20,000 in agent commissions and other fees at the sale. Then you can deduct another $25,000 from your profit. Your taxable capital gain is now down to $65,000.
How Do I Calculate My Capital Gains Tax Liability?
You do not pay Capital Gains Tax on the entire sales value of the property, only on the amount that is counted as gains. You are permitted to deduct certain expenses from your gain to reduce your tax liability. These include estate agent’s fees, solicitor’s fees and the cost of any improvement work. You cannot deduct the costs of decorating or maintaining the property.
Gains = Purchase Price – (Sale Price + Buying & Selling Costs + Improvement Costs)
To calculate how much GCT you will need to pay, deduct your annual GCT allowance from your gains. You must pay Capital Gains tax on this amount.
Add you capital gain to your taxable income to determine whether you pay the lower or higher rate of CGT.
GCT Payable = (Gains – GCT Allowance) x GCT Tax Rate.
The government has provided an online capital gains tax calculator, which will help you assess your liability.
From 6 April 2020, you need to report the gain to HMRC on a GCT return and pay the tax within 30 days of completion. Failure to pay within 30 days will result in penalties and interest charges. Given the tight deadline, you’ll need to make sure you have gathered together all the relevant information required in advance. This includes:
• The date you acquired the property
• The costs of purchase and disposal. Including purchase price and sale price, stamp duty, estate agent fees from the sale, surveyors fees from the purchase, legal fees from the purchase and sale.
• Costs of eligible home improvements
• Your earning in the tax year
The tax due is an estimated amount at the time of the gain and could change if the person’s earnings change the tax bracket they fall into. The amount paid is treated as a payment on account and processed on the individual’s self-assessment tax return. Most people are expected to submit their CGT return online via the HMRC’s government gateway. If you don’t have an account, you’ll need to apply for one. As this can take up to 10 days, make sure you have done this in advance of completing the sale.
Example
For a second home or buy to let property sold on 7 April 2021, the GCT return will need to be submitted and paid by 6 May 2021. The capital gains calculations will be included in the self-assessment tax return due by 31 January 2022. Should any further tax be payable or refund due, it will be calculated at this point. Any additional tax must be paid by 31 January 2022.
Changes To Private Residence Relief
If you have lived in the property as your main residence for the entire period of ownership, private residence relief means that any gain you make is exempt from CGT. Special rules govern partial private residence relief if you have lived in the property for some of the time. These rules changed in April 2020. Before April 2020, if the property had been your home at some point in the 18 months prior to the sale this part of the gain would be exempt from tax. For sales on or after 6 April 2020 this relief period is reduced to 9 months. This change affects people who are purchasing a home before selling their old one. They now have just nine months to sell their old property to avoid a potential CGT charge.
Changes To Lettings Relief
Under the old rules, if you sold a residential property that was once your main residence but had then been rented out, it was possible to deduct lettings relief of up to $40,000 from any capital gain. However, from April 2020, lettings relief is now only available for people in shared occupancy with their tenant/tenants, so is no longer available to the vast majority of people.
First, How Much Is Your Gain?
Many people mistakenly believe that their gain is simply the profit on the sale: “We bought it for $100,000 and sold it for $650,000, so that’s a $550,000 gain, and we’re $50,000 over the exclusion, right?” It’s not so simple a good thing, since the fine print can work to your benefit in such instances. Your gain is actually your home’s selling price, minus deductible closing costs, selling costs, and your tax basis in the property. (Your basis is the original purchase price, plus purchase expenses, plus the cost of capital improvements, minus any depreciation and minus any casualty losses or insurance payments.) Deductible closing costs include points or prepaid interest on your mortgage and your share of the prorated property taxes.
Examples of selling costs include real estate broker’s commissions, title insurance, legal fees, advertising costs, administrative costs, escrow fees, and inspection fees.
So, for example, if you and your spouse bought a house for $100,000 and sold for $650,000, but you’d added $20,000 in home improvements, spent $5,000 fixing the place up for the sale, and paid the real estate brokers at least $25,000, the exclusion plus those costs would mean you’d owe no capital gains tax at all.
If You Don’t Meet the Use Test
Now let’s say that you still have some capital gains that don’t seem to fall under the exclusion. Even if you haven’t lived in your home a total of two years out of the last five, you’re still eligible for a partial exclusion of capital gains if you sold because of a change in your employment, or because your doctor recommended the move for your health, of if you’re selling it during a divorce or due to other unforeseen circumstances such as a death in the family or multiple births. In such a case, you’d get a portion of the exclusion, based on the portion of the two-year period you lived there. To calculate it, take the number of months you lived there before the sale and divide it by 24.
For example, if an unmarried taxpayer lives in her home for 12 months, and then sells it for a $100,000 profit due to an unforeseen circumstance, the entire amount could be excluded. Because she lived in the house for half of the two-year period, she could claim half of the exclusion, or $125,000. (12/24 x $250,000 = $125,000.) That covers her entire $100,000 gain.
Nursing Home Stays
For people who’ve moved to a nursing home, the ownership and use test is lowered to one out of five years in your own home before entering the facility. And time spent in the nursing home still counts toward ownership time and use of the residence. For example, if you lived in a house for a year, and then spent the next five in a nursing home before selling the home, the full $250,000 exclusion would be available.
Marriage and Divorce
Married couples filing jointly may exclude up to $500,000 in gain, provided:
• either spouse owned the residence
• both spouses meet the use test, and
• neither spouse has sold a residence within the last two years.
Separate residences. If each member of a married couple owns and occupies a separate residence and files jointly, each may exclude up to $250,000 in gain when they sell. Also, if it’s a new marriage and one spouse sold a residence within two years before the marriage (thereby disqualifying him- or herself from the exclusion), the other spouse may still exclude up to $250,000 in gain on a residence owned before the marriage.
A new marriage may also double the tax break in some circumstances. Suppose a single man sold his principal residence on October 1 and gained $500,000 in profits. Let’s also say that he and his girlfriend had been living in the house for two years (but her name wasn’t on the title), so they both satisfy the use test. If they get married by midnight December 31 of the same year, they can file a joint return for that year and exclude the entire $500,000.
Divorce and the tax break. Divorced taxpayers may tack on the ownership and use of their residence by their former spouse. For example, say that upon divorce, the wife is allowed to live in the husband’s residence until she sells it. He has owned the residence for 18 months. Once the sale occurs, the couple will split the profits 50-50. If the wife sells the home nine months later, she may tack on her ex-husband’s ownership to meet the two-year ownership test. Also, the husband may tack on his ex-wife’s continued use of the residence to meet the two-year use test. Each one is entitled to exclude $250,000 of profits from the sale. Widowed taxpayers may also tack on the ownership and use by their deceased spouse.
Reduced Exclusion for Second Home Also Used as Primary Home
If you sell a home that you sometimes used as a vacation or rental property and sometimes as your primary residence, you’re eligible for only that portion of the capital gains exclusion that corresponds to the amount of time you actually lived there as your primary residence. (The rest of the time is called “non-qualifying use.”) Note that the calculation is made over more than a mere five-year period — it applies right back to January of 2009. What’s more, if during the five years before the sale, you never actually made the home your primary residence, you’re likely disqualified from using the exclusion. (You won’t be surprised to hear that this new rule was meant to generate additional tax revenue to offset some other tax cuts.)
Home Offices: A Tax Drawback
The exclusion does not apply to depreciation allowable on residences after May 6, 1997. If you are in a high tax bracket and plan to live in your home for a long time, taking depreciation deductions for a home office is quite valuable right now. But if not, you might want to reconsider using a portion of your home as an office, because all depreciation deductions you take will be taxed at 25% when you sell the house.
Example: A married couple sells a home with an adjusted basis (purchase price plus capital improvements) of $100,000 for $600,000. Over the years, they had taken $50,000 in depreciation deductions for a home office.
Sales Price: $600,000
Adjusted Basis – $100,000
Taxable gain = $500,000
Of that gain, $450,000 is tax-free; the $50,000 taken as depreciation deductions is subject to 25% capital gains tax.
Splitting Up Big Gains
If you expect huge gains from selling a house — more than can be excluded from tax — you should consider ways to divide ownership of the house.
For example, say a couple owns their residence together with their adult son (perhaps because they’ve given him a share). If he meets the ownership and use tests as to one-third of the property, the son may sell his share for a $250,000 gain without incurring a tax. His parents could simultaneously sell their share for $500,000 without tax, sheltering the entire $750,000 gain.
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