Overview

Selling a second home or a vacation rental involves more than signing closing papers. Taxes can materially affect your proceeds. The main steps are: verify your adjusted basis, calculate capital gain, determine whether depreciation recapture applies, check eligibility for any exclusions or deferral strategies (like a 1031 exchange), and report the sale correctly to the IRS.

In my practice as a CPA advising homeowners and real estate investors, I routinely see missed deductions and documentation gaps that increase tax bills. The guidance below synthesizes current IRS rules (2025) and practical planning steps.

Sources: IRS Publication 523 (Selling Your Home), IRS Topic 701 (Sale of Your Home), IRS Topic 703 (Basis of Assets), and IRS Publication 527 (Residential Rental Property) (see links at the end).

Step 1 — Identify the property use and ownership timeline

Taxes depend on how you used the property over time:

  • Purely personal second home (no rental activity): treated as a personal residence for tax-loss rules — losses generally nondeductible; gains taxable as capital gains.
  • Rental property (short-term or long-term rentals): treated as investment property; you report rental income while you owned it and claim depreciation; on sale you face capital gain plus potential depreciation recapture.
  • Mixed-use (both personal and rental): you must allocate basis, depreciation, and gain between personal- and rental-use periods. See IRS Publication 527 for allocation rules.

Critical dates: the date you acquired the property, dates you converted it to rental or back to personal use, and the date of sale.

Step 2 — Calculate adjusted basis (purchase price + improvements − depreciation)

Your adjusted basis is the foundation for any tax calculation. Include:

  • Purchase price, plus closing costs that add to basis (title fees, recording fees),
  • Capital improvements that add value or extend life (roof, new HVAC, structural additions). Routine repairs are not capitalized.
  • Subtract any depreciation you claimed or were allowed while property was used for rental (see depreciation recapture below).

Keep organized records: invoices, bank statements, closing disclosures, and contractor contracts make audits easier and reduce the chance of missed basis increases.

Reference: IRS Topic 703 (Basis) (https://www.irs.gov/taxtopics/tc703).

Step 3 — Compute gain and determine short-term vs long-term treatment

Capital gain = Amount realized (sale price minus selling costs such as commissions and transfer taxes) − Adjusted basis.

  • Short-term gains (property owned one year or less) taxed at ordinary income rates.
  • Long-term gains (owned > 1 year) taxed at long-term capital gains rates (0%, 15%, or 20% depending on taxable income) plus potential Net Investment Income Tax (NIIT) of 3.8% for high earners.

Report gains on Form 8949 and Schedule D; if depreciation recapture applies, portions may be reported on Form 4797 (see Step 5) (IRS instructions for Forms 8949/Schedule D).

Step 4 — Consider the primary residence exclusion and partial exclusion rules

The principal residence exclusion ($250,000 single / $500,000 married filing jointly) under Internal Revenue Code §121 applies only if you meet ownership and use tests: you owned and lived in the home as your primary residence for at least 2 of the 5 years before the sale.

  • If the property was never your primary residence, the full exclusion does not apply.
  • If you converted a second home or rental to your primary residence, you may qualify for a partial exclusion based on the time it was your primary residence and certain hardship or job-related moves — but conversion often triggers depreciation recapture and reduces the exclusion.

See IRS Publication 523 and Topic 701 for examples and rules (https://www.irs.gov/publications/p523).

Step 5 — Depreciation recapture: what to expect when selling a rental portion

Depreciation you claimed while the property was a rental reduces your basis and creates a recapture tax when you sell. For residential real property, depreciation is generally recovered under Section 1250 rules and taxed up to 25% as unrecaptured Section 1250 gain (reported on Form 4797 and Schedule D).

Key points:

  • Any depreciation claimed (or allowed) while the property was used for rental is taxable on sale, even if you didn’t claim it.
  • The recaptured amount is taxed at a maximum 25% rate for unrecaptured Section 1250 gain; any additional capital gain uses the regular long-term capital gains rate.

IRS guidance: see instructions for Form 4797 and Publication 527.

Step 6 — Deferral options: 1031 exchanges and timing strategies

If the property was held for investment (not personal use), a Section 1031 like-kind exchange can defer capital gains and depreciation recapture by swapping into another qualifying investment property. The exchange must meet strict timing and identification rules and is reported on Form 8824.

  • 45-day identification period and 180-day acquisition window are strict deadlines.
  • Work with a qualified intermediary; never receive the sale proceeds directly if you want deferral.

Useful internal reading: FinHelp’s guide to 1031 exchanges (https://finhelp.io/glossary/1031-exchange/) and our piece on tax planning for second homes and vacation rentals (https://finhelp.io/glossary/tax-planning-for-second-homes-and-vacation-rentals/).

Step 7 — Reporting, withholding, and closing paperwork

Common paperwork and reporting items to expect:

  • Form 1099-S: Proceeds from Real Estate — often issued by the closing agent if reporting is required.
  • Form 8949 and Schedule D: Report capital gains and losses.
  • Form 4797: Report depreciation recapture for disposition of business or rental property.
  • Form 8824: If you completed a 1031 exchange.

If the buyer is a foreign person, FIRPTA withholding rules may apply (withholding on sale to foreign persons).

Practical examples

Example 1 — Vacation rental sold with depreciation
Purchase price: $500,000
Improvements: $100,000
Allowed depreciation over rental years: $50,000
Sale price less selling costs: $800,000
Adjusted basis = 500,000 + 100,000 − 50,000 = 550,000
Gain = 800,000 − 550,000 = 250,000
Taxable components: depreciation recapture ($50,000 taxed at up to 25%) + remaining long-term capital gain taxed at capital gains rates.

Example 2 — Convert second home to primary residence to seek exclusion
If you convert and live in the property long enough to meet the 2-of-5-years test, you could qualify for a partial or full §121 exclusion. Carefully track periods of rental vs personal use and calculate depreciation recapture which reduces exclusion benefit.

Recordkeeping checklist (what I ask clients to gather)

  • Closing Disclosure/Settlement Statement at purchase and sale.
  • Receipts and invoices for capital improvements.
  • Depreciation schedules from tax returns (Form 4562 entries).
  • Rental income and expense records, and calendars showing personal vs rental use.
  • Any 1031 exchange correspondence and qualified intermediary statements.

Good documentation can reduce audit risk and preserve basis increases.

Common mistakes and how to avoid them

  • Failing to track or report depreciation: leads to unpleasant recapture and penalties.
  • Misapplying the primary residence exclusion: the rule is strict — meet the 2-of-5-years test and document your use.
  • Trying a DIY 1031 exchange: missing deadlines is costly — use a qualified intermediary and tax counsel.

Next steps and professional guidance

If you’re planning a sale in the next 12 months, run the numbers early. In my experience, small adjustments (accelerating a capital improvement, timing the sale across tax years, or qualifying for a 1031 exchange) can change the after-tax outcome materially.

Consult your CPA or tax attorney before you sell. The guidance above is educational and general in nature and not a substitute for personalized tax advice.

Authoritative resources

Professional disclaimer: This article provides general information for educational purposes and does not constitute tax, legal, or financial advice. Consult a qualified CPA or tax attorney to apply these concepts to your situation.