Goodspeed: Difference in taxes owed on primary and vacation homes

Linda Goodspeed

QUESTION: According to what I understand, if I sell my vacation home, I will have to pay taxes on the sale. But if I leave the home to my two children, they will not have to pay any taxes as long as they sell the home shortly after my death. Am I correct?

Answer: Not all real estate is equal, tax-wise, in the eyes of the IRS. Primary residences and vacation or investment homes are treated differently.

For example, the IRS gives homeowners who sell a primary residence a huge tax break as long as they have lived in the home as their primary residence for two out of the last five years. If they meet that definition and sell the home for a profit, they will not have to pay any federal taxes as long as the profit does not exceed $250,000 for a single homeowner or $500,000 for a married couple.

Not so with a vacation or investment property. When you sell your vacation home, you will have to pay federal taxes on any profit you make on the sale. If you own the vacation or second home for more than a year, the profit is usually taxed at the capital gains tax rate which can be as high as 20 percent plus the 3.8 percent net investment income tax. You might pay less than this, but the bottom line is that you will have to pay taxes on the sale of your vacation home.

On the other hand, if you let your children inherit the vacation home, your children will receive the property at a value determined at the time of your death. This is known as a “stepped-up” basis. Under this rule, if you paid $100,000 for the home and when you die, the home is worth $300,000 and your children sell the home shortly after they inherit it for $300,000, they will pay no taxes on the sale.

If your children hold onto the property after you die and some years later sell it for $500,000, they will have to pay taxes on the $200,000 profit over the stepped-up basis of $300,000.

The IRS usually allows heirs to claim the sale price as the value of the home as long as the home is sold within a year of your death. But they will pay capital gains taxes on any profit if the home is sold after the first year.

If your children plan to hang onto the home for a while, they should have an appraisal done at the time of your death to ascertain its value at that time.

Linda Goodspeed is a longtime real estate writer and author of “In and out of Darkness.” Email her at: