Capital Gains Tax on Vacation Properties

Capital gains tax exclusions may apply to vacation properties if they meet certain criteria. First, it is important to understand that the capital gains tax on a primary residence can be excluded on up to $250,000, if filing separately, or $500,000, if married filing jointly, of profit (figures current in 2010). Since a vacation home is not a primary residence, this exclusion will not apply. There are several ways to gain the exclusion on the property.

Residency Requirements

If you have lived in your vacation home full time at least 2 of the 5 years preceding its sale, the home will qualify as a principal residence. You must be able to prove you were living there full time, and you must not be declaring another principal residence for the exclusion during the same tax period. This exclusion often applies to a business person who maintains residence in two separate cities, living in one for a time as business necessitates. With proper planning, you may elect to live in the vacation home for tax benefits alone, but this situation can be challenging to establish if your primary job and residence are elsewhere.

Retirement Options

If you are considering where to retire, you may have the option of either remaining in your current primary residence or in your vacation home. During this period, you may find your primary residence changes quite often. Then, upon deciding to sell your vacation home, you may find you are still stuck with a large capital gains tax bill. Instead of paying this, which amounts to an additional income tax, you may treat the vacation home as if it were a primary residence. This takes planning well ahead of time, so you should ask your accountant about this option if you feel you will be between two residences as you enter retirement.

1031 Exchange Benefits

One way to defer capital gains tax on a property is to complete a "like kind" purchase with the profit. Instead of paying taxes on the profit today, you can roll the profit over into a similar investment and pay taxes when that second investment is sold. For a vacation home to qualify for this "1031 exchange," you will need to use the home less than 10 percent of the time or fewer than 14 out of 365 days. This will qualify the home as an investment property and not a residence, making it eligible for the 1031 option.

Investment Expense

When you own an investment property, upkeep on that property is tax deductible as an expense of running the "business." So, if you are residing in a home less than 10 percent of the year and renting it out during the other times, you can deduct expenses to manage the property. For example, repairs made to the roof, windows or carpets would all be business expenses. Some improvements may also qualify. The key to capturing these benefits, as with all deduction benefits, is proper record keeping. Ensure you are keeping receipts and recording the purpose of each transaction. This will help your accountant categorize and file your deductions come tax season.