Capital Gains Tax on a Second Home Explained

A second home, sometimes called a vacation home, sits in a gray area between a primary residence and a straightforward investment property. It does not qualify for the Section 121 exclusion, since that exclusion is reserved for a primary residence that meets the ownership and use tests. It also does not automatically qualify for a 1031 exchange, since the exchange requires the relinquished property to be held for investment or business use, not primarily for personal enjoyment.

When a second home sells, gain above the adjusted basis is taxed at long term capital gains rates if held more than one year, the same zero, fifteen, or twenty percent federal brackets that apply to other capital assets, plus the net investment income tax where it applies. Colorado, CO owners of a second home located in the state, or Colorado residents selling a second home elsewhere, owe state income tax on the gain as well, since Colorado does not provide a separate rate or exclusion for vacation property.

The Internal Revenue Service has provided a safe harbor, found in Revenue Procedure 2008-16, that lets a second home qualify for a 1031 exchange if it was rented at a fair rental for at least fourteen days in each of the two twelve month periods before the exchange, and the owner's personal use did not exceed the greater of fourteen days or ten percent of the days it was rented at fair value during each of those two years. Meeting this safe harbor converts the property, for tax purposes, into one that is treated as held for investment, opening the door to a 1031 exchange.

Owners who have used a mountain property, a rental condo, or similar second home mostly for personal enjoyment do not meet this safe harbor and cannot exchange it without first changing how the property is used and documented over a sustained period. Owners considering this path should plan well ahead, since the safe harbor looks at usage over the two years immediately preceding the exchange, not usage that starts after the decision to sell has already been made.

Denver, CO investors with mountain property in resort areas around the state frequently face this exact question, since many of these properties were purchased for a mix of personal use and short term rental income. Reviewing the actual rental and personal use days against the safe harbor thresholds before listing the property is the only reliable way to know whether an exchange is available.