Guides

Second Home Capital Gains Tax

A second home or vacation property, such as a coastal condo in La Jolla or Del Mar used only part of the year, is generally treated differently than either a primary residence or a straightforward rental property when it comes to capital gains tax. Because the Section 121 exclusion generally requires the property to have been used as the owner's primary residence for at least two of the five years before the sale, a second home that was never lived in as a primary residence generally does not qualify for any exclusion, and the full gain is generally exposed to federal long term capital gains rates, potential net investment income tax, and California's ordinary income tax treatment. Some San Diego, CA second home owners assume that because they never rented the property, it should be treated favorably like a rental exchange candidate, but a property held purely for personal enjoyment generally does not meet the investment or business use requirement of Section 1031 either, leaving the owner without either form of relief. The path that can generally open a second home to 1031 treatment is converting it to a genuine rental property before the sale. The Internal Revenue Service has not published a bright line holding period for this conversion, but Revenue Procedure 2008-16 generally offers a safe harbor many practitioners rely on, which generally suggests renting the property at fair market rent for at least fourteen days in each of two consecutive twelve month periods before the exchange, while limiting the owner's personal use in each of those years to the greater of fourteen days or ten percent of the days the property was actually rented. Meeting this safe harbor does not guarantee 1031 eligibility, since the Internal Revenue Service still generally looks at the taxpayer's overall intent, but it generally provides a documented pattern of investment use that supports the position. San Diego, CA owners considering this path for a coastal second home should generally start the conversion well before a planned sale, keep clear rental records including lease agreements, rent receipts, and advertising history, and generally limit personal use during the qualifying period. Because the line between personal and investment use is a facts and circumstances test rather than a fixed rule, this is an area where working with a tax advisor early, before listing the property, generally matters more than with a straightforward rental sale. Educational content only. This is not tax, legal, or investment advice, and second home owners should confirm any conversion strategy and its 1031 eligibility with a qualified tax advisor well in advance of a sale.