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Selling

Selling a Vacation Home? Plan Ahead Now or Pay the Taxman Later

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vacation home for sale

There's simply nothing like a vacation home -- the escape from everyday life, the solitude, the relaxation. Also: the extra upkeep, extra mortgage, extra hassle. It's little wonder that when the seasons start changing, many people start thinking more and more about shedding a no-longer-needed vacation home. All good things must come to an end (or so we're told).

But do it right. When it comes time to sell your getaway, there are some things you should know about taxes.

"We do have a lot of clients that end up selling a property and have a huge tax bill," says tax expert Ryan Parker. "If you're thinking about selling it, the first thing you should do is do some tax planning."

And a lot of people could use that advice: 920,000 vacation homes were sold in 2015, the second-highest number since 2006, the National Association of Realtors reported in its 2016 Investment and Vacation Home Buyers Survey.

But selling a vacation home is not quite like selling your primary residence as far as Uncle Sam and the IRS are concerned. Here's a guide to what you need to know, according to the tax laws for 2015 (and be sure to stay attuned throughout the year for any changes for 2016).

Selling a vacation home is just like selling stock

The proceeds from the sale of any home that you own are considered capital gains. Although the IRS will cut you a break when you sell your primary residence (the first $500,000 in profit for a married couple is exempt from taxes, $250,000 for a single person), that's not the case for a vacation home. You'll pay a capital gains tax just as if you had sold some stock shares.

The two key variables are your income tax bracket and what you paid for the home. For 2015, the capital gains tax was no higher than 15% for most taxpayers, according to the IRS. Those in the very top bracket had to pay 20%.

You pay capital gains taxes on the net proceeds from the sale of your home, or the money you received for your house when you sold it minus the combination of closing costs and what you paid for it. You may hear references to your basis -- that's taxspeak for what a house originally cost.

If you bought a house for $200,000 (that's your basis) and sold it for $300,000, with closing costs of $10,000, you would pay tax on $90,000. That could be 15% or higher, depending on your tax bracket.

(Selling a primary residence is subject to capital gains taxes, too, but the first $500,000 in profit for a married couple is exempt from taxes; it's $250,000 for a single person.)

Keep track of what you spent on improvements

The money you spent on home improvements increases your cost basis -- and that reduces the net proceeds. You must keep records of all improvement costs. If you spent $25,000 adding a rec room in the above example, that would make your basis $235,000, cutting your taxable gain to $65,000.

And sorry: Improvements, for tax purposes, don't include routine maintenance. After all, fixing a leaky faucet or patching some plaster doesn't add to your home's value -- it just keeps the place working and in good shape. We know, bummer.

Understand what depreciation means

Owners of vacation properties who've been renting them out can deduct depreciation -- the wear and tear on a property that lowers its value over time -- when filing their annual taxes. Taking depreciation annually can lower your income tax payments on the rental income you receive, but it also lowers the basis you claim when selling. And that, in turn, increases your capital gain.

An annual depreciation of $5,000 for 10 years on that $200,000 vacation home you rented out, would be $50,000 in total depreciation. If you sell the house for $300,000, you'll pay capital gains on $150,000: your $100,000 gain plus the $50,000 in depreciation that gets subtracted from the basis.

Know the residency requirements

Another way to cut capital gains taxes is to make your vacation home your permanent residence. If you live in a home two of the five years before you sell it, it is considered your permanent residence by the IRS. States have varying residence requirements, so it's best to check with the one in which you live. Proof of primary residence includes the address on your driver's license, utility bills, and where you register to vote.

Don't sell it, swap it

A1031 exchange is a special tax provision that allows you to put off paying tax on the sale of your vacation house. How? It involves swapping your house for another of similar value. This can be used only for investment properties, so you must be renting out your vacation home to swap it, and you must swap it for another vacation rental. Got that? You then need to wait five years before you can make the new rental your primary residence. Finding swap partners usually requires using a firm that specializes in setting up such deals. Note: You'll postpone, not eliminate, paying taxes on your place.

Offset your gains

Capital gains from a second home sale can be reduced by capital losses you have in the year you sell your house. So if you lost money on stocks and bonds, sell them when you sell your house to offset some of your house gain.

Leave it to the kids

If you leave a vacation home to children or others in your will, their basis becomes what the home is worth when they inherit it. If that $200,000 vacation home is worth $400,000 when you die, your children's basis would be $400,000, essentially sheltering the $200,000 gain.

Of course, sometimes you just can't stop the taxman from coming: you might not be able to live in your vacation home for a couple of years; you might not have plied the place with improvements; and you might be long from the time when you leave it to the kids. In that case, our advice is to enjoy your vacation home for as long as you can, and then brace yourself for the bill. Because vacation homes are awesome. And contrary to popular wisdom, the best things in life are not always free.

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