Owning a second home can create unexpected tax traps as well as tax-saving opportunities, says attorney Timothy B. Borchers, coauthor of the upcoming edition of Saving the Family Cottage.
Here are seven tax matters worth knowing about if you currently own a second home or are considering buying one, including how to avoid second-home taxes…maximizing the tax benefits…and the tax consequences of selling a second home and of renting one out…
1. Avoiding capital gains taxes when selling a second home takes some planning. Section 121 of the Tax Code allows homeowners to exclude up to $250,000 of capital gains—up to $500,000 when married and filing jointly—when selling a home. But this exclusion applies only to primary residences.
Solution: Use your second home as your primary residence for at least 24 months (at least 370 total days, which do not have to be consecutive) during the five-year-period leading up to the sale date. By doing this and following a few other rules, the second home likely will qualify for the capital gains tax break.
To establish your second home as your primary residence: Use the second home’s address when you register to vote…get a driver’s license…and on your tax forms. Spend the majority of the days of the year there—keep receipts and records to prove you were living in that home more often than not.
You can claim the capital gains tax exclusion on multiple homes during your lifetime but not on more than one home within any two-year period, so it’s best not to sell multiple appreciated properties in quick succession. See IRS Publication 523, Selling Your Home, for additional details.
2. You probably can’t deduct the property tax bills for your second home. Taxpayers who itemize their returns can deduct state and local taxes from their federal income taxes—but under rules in effect for 2018 to 2025, this deduction is capped at $10,000 ($5,000 for married persons filing separately) each year. People who own second homes…and even third homes…often pay well above that threshold when property tax bills and other state and local taxes are totaled up for the multiple homes. That leads to higher overall taxes than they would have faced without the cap. This cap could be raised after 2025, but that’s far from certain.
3. Having homes in multiple states can cause sticky income tax issues …or present attractive tax-savings opportunities. If you maintain homes in more than one state, you might be able to trim your taxes by making the home in the lowest-tax state your primary residence. But beware: The high-tax state where you have a home might go to surprising lengths to determine whether you actually owe taxes in that state. Close scrutiny is especially likely if you shift your primary residence out of a very high-tax state, such as California or New York, while continuing to own property there.
Take the same steps as above to establish your second home as your primary residence. Also: Switch to a primary-care physician in the low-tax state.
Warning: If you earn income in the high-tax state, you might owe taxes there on that income as a nonresident even if you officially reside in a different state—details vary by state.
4. Having homes in multiple states presents estate-tax gotchas and opportunities. The federal estate-tax exemption is currently a steep $13.61 million. But many states have estate and inheritance taxes of their own, and some have exemptions so low that even families that aren’t exceptionally wealthy are affected. Examples: In Oregon, estate taxes affect estates as small as $1 million, as of 2024…in Rhode Island, they kick in at approximately $1.774 million…in Massachusetts, at $2 million…in Washington state, at $2.193 million…and in Minnesota, at $3 million.
What do state estate taxes have to do with owning two homes? Two things…
If your primary residence is in a state where you face state estate taxes, owning a property in another state could reduce or avoid a future estate-tax bill—out-of-state property often is excluded from states’ estate-tax calculations. Laws on this subject vary from state to state, so talk with your tax preparer and/or estate-planning attorney.
If your second home is in a state where estate taxes are a possibility, consider having an LLC set up that legally owns that home. This ownership structure could allow your family to avoid future estate taxes related to the second home’s value, depending on your state. Seemingly small details are important here, so work with an attorney who has experience setting up LLCs for this purpose.
Example: In Maine, an LLC must not be a single-member entity (disregarded, meaning not treated separately from the owner for tax purposes) to avoid state estate taxes—so holding the property in a multi-member LLC (one that has to file its own tax returns) would avoid estate taxes.
5. Certain home-improvement costs can be used to offset future capital gains. If you face capital-gains taxes when you sell your second home—it isn’t always possible to qualify for the Section 121 exclusion described earlier—you can at least reduce that capital-gains tax bill by subtracting the cost of certain improvements you’ve made to the property from your taxable profit. To do this, you’ll need records that document these expenses, such as receipts and invoices. Some of those records might date back years or even decades if you’ve owned the property for a long time.
Not every home-improvement expense qualifies to offset capital gains…only those that are considered “capital improvements.”
Rule of thumb: Big stuff such as remodeling…having an addition put on…putting in a swimming pool…or replacing the siding or roof tend to qualify. Smaller, standard upkeep costs such as having walls repainted typically does not. Rather than try to figure out what does and doesn’t qualify, save your receipts and invoices for all home-improvement costs, then let your experienced tax preparer sort through them.
Helpful: If you sometimes rent out your second home, property-upkeep expenses might be deductible even if they don’t qualify as capital improvements—more about tax issues related to rentals below.
A second home can be an income source if you rent it out when you’re not staying there—but there are some tax details worth knowing…
6. There’s a tax break for people who rent out properties only rarely. There is a way to rent out your second home—or for that matter, your primary residence—and not owe income taxes on the proceeds.
According to section 280A of the Tax Code, it isn’t necessary to report rental income as taxable income as long as the property is a personal residence and is rented out for 14 days or fewer during the year. There’s no cap on how much tax-free income you can take in during these 14 rental days, as long as the amount is reasonable for the time and location. If you rent out your second home when there’s a popular event or major convention in the area, you might be able to earn substantial tax-free income. Example: Some people who live in or near Augusta, Georgia, generate tens of thousands of dollars of tax-free income each year by renting out their homes during the Masters golf tournament.
7. “Depreciation recapture” could take a tax bite when you sell a home you’ve previously rented. You have to pay income taxes on your rental income if you rent out a property for more than 14 days in a year—and, if so, you will receive a tax deduction based on that home’s depreciation. If you receive this depreciation tax deduction: You might later face a tax bill. If the home’s eventual sales price is greater than the purchase price minus the depreciation deductions claimed over the years, then the total amount of depreciation deductions you received is considered capital gains—and likely will be taxed after the home is sold as capital gains up to a maximum rate of 25%.
