Selling Your Vacation Home? Tax-Smart Strategies to Consider

In many popular vacation destinations, property values and insurance costs have soared. If your vacation home has appreciated significantly, now may be a good time to sell. While you could simply sell and accept the tax bill, three tax-saving strategies are worth considering.

Option 1: Convert the Property into Your Principal Residence

By living in your vacation home for at least two years before selling, you may qualify for the home sale gain exclusion, one of the most generous personal tax breaks available:

• $250,000 for eligible single filers
• $500,000 for married couples filing jointly
• $250,000 each for married individuals filing separately

To qualify, you must pass:

• Ownership test: You owned the home for at least two of the last five years
• Use test: You used the home as your principal residence for at least two of the previous five years

Important: To claim the full $500,000 exclusion, at least one spouse must meet the ownership test, and both must meet the use test.

However, if the property was used as a rental before becoming your residence, a portion of the gain may not be excludable. See the section "Computing Nonexcludable Gains" for more.

Option 2: Use a Tax-Deferred Section 1031 Exchange

If your vacation home has been rented out, you may qualify for a Section 1031 like-kind exchange, which lets you defer capital gains taxes by reinvesting the proceeds in a similar property.

To qualify:

The relinquished property must have been:

• Owned for at least 24 months before the exchange
• Rented at fair market value for 14+ days in each of the two years
• Used personally for no more than 14 days or 10% of the rental days

The replacement property must also be:

• Owned for at least 24 months
• Rented for 14+ days per year with limited personal use

If done correctly, gains are deferred until the replacement property is sold. If the property is held until death, the basis is stepped up to fair market value, potentially eliminating all capital gains tax.

Note: Section 1031 exchanges are complex. Consult a tax advisor before proceeding.

Option 3: Hold the Property

Holding the property until death may be a smart long-term move due to the step-up in basis rule. Upon death, the property's basis is adjusted to its fair market value, eliminating taxable gain accrued during your lifetime.

Your heirs would only pay tax on gains accrued after your death. This strategy may make sense if:

• You're in no rush to sell
• Your family has emotional ties to the property
• You want to minimize taxes for your heirs

If the property is jointly owned with a spouse, special rules apply, so speak with your tax advisor.

Computing Nonexcludable Gains on Vacation Homes

Some gains might not qualify for exclusion if you converted your vacation home into your principal residence. Here's how to calculate the nonexcludable portion:

1. Depreciation Recapture: Determine any depreciation claimed after May 6, 1997. This portion is taxed at up to 25%.
2. Nonqualified Use Fraction: Divide the time the property was not used as your principal residence (after 2008) by the total ownership period.
3. Apply the Fraction: Multiply the remaining gain (after Step 1) by the fraction to determine the nonexcludable gain.
4. Eligible Exclusion: The rest of the gain may qualify for exclusion if ownership and use tests are met.

Timing Considerations and Tax Rates

Selling in a low-income year could reduce your tax bill. Here's how long-term capital gains (LTCG) rates work:

2026 taxable income thresholds for the 20% rate:

• Single: $545,500
• Head of Household: $579,600
• Married Filing Jointly: $613,700
• Married Filing Separately: $306,850

Most taxpayers will pay 15%, unless income exceeds these thresholds. High earners may also owe an additional 3.8% Net Investment Income Tax (NIIT), resulting in effective rates of 18.8% or 23.8%.

Consider selling in a year when:

• Your income is lower (e.g., retirement)
• You've realized capital losses elsewhere

More Than Just Taxes

While tax planning is important, decisions about vacation properties are also personal. Consider:

• Emotional and family ties
• Your age, health, and lifestyle goals
• Financial needs and estate planning

Work with your financial, legal, and tax advisors to decide which option is right for you.

How We Can Help

Selling a vacation home touches income tax, estate planning and family goals all at once. Our individual tax team can run the numbers on each option and coordinate with your financial and legal advisors.

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