Convert your second home to investment property, then exchange.
While it’s true that the sale of your second home will trigger capital gains tax, it is also true that your second home can be converted to take advantage of the tax relief codified in either Section 121, sale of a primary residence or Section 1031, sale of investment/rental property treatment.
Convert to your primary residence: Section 121 provides for an exclusion from capital gains tax upon the sale of your primary residence of up to $250,000 per taxpayer or $500,000 for a married couple filing jointly. It requires that the property be converted from your second home to your primary residence for two years preceding the sale. Upon sale, the exclusion will be prorated since it was once investment property in your hands but a partial exclusion is better than a tax deferral any day. If you elect this strategy, move in and make sure all of your records reflect your new address; this cannot be a sham. The tax savings can be substantial and there isn’t any requirement to reinvest the proceeds in new property.
Convert to investment/rental property: Section 1031 provides a deferral from depreciation taken since May 1997, capital gains tax at the federal and state levels. These combined taxes can amount to as much as 30% of the gain. Again, the strategy is to convert the second home to rental property for two years prior to sale. In many resort areas, the property can be listed with the rental pool of available properties with the management responsibilities transferred to an onsite manager. The property will be shown on your tax return as rental property and deductions for expenses and depreciation are allowed. This may make holding the property a bit longer easier to manage financially. Rent the property for a minium of 14 calendar days in the two years leading up to sale, keep good records, and limit your personal use to 14 calendar days or 10% of the days actually rented, whichever is greater. Upon sale, exchange the property for other investment property and rent the new property for the following two years.
If your second home has become a burden, taking one of these two steps can bring you closer to an eventual sale that does not carry the impact of taxes.
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