Ways to reduce your capital gains tax The capital gains tax may seem high, but don’t kiss all of those tax dollars away just yet. Depending on your situation, there are several different ways that you may be able to mitigate some of your capital gains. Adjust your profits to reflect any acquisition costs or property improvements At the most basic level, capital gain is calculated by determining your cost basis and subtracting any profit made from the sale. The cost basis is typically the amount you spent to buy and improve your second home, including the purchase price, any acquisition or closing fees, and the cost of any capital improvements you made while owning it. Capital improvements are permanent repairs or upgrades not including routine repairs or maintenance. For a list of the capital improvements you can add to the cost basis of your home, see IRS Publication 530. You can also increase your cost basis by adding any qualifying real estate fees, such as real estate commission and closing costs, paid when selling your second home, which can reduce your taxable gain even further. How to calculate capital gains tax Remember that the capital gains tax depends on marital status, how long you’ve owned your home, your taxable income, and your net profit. For example, if you’re married filing jointly with a net combined income of $233,000, and you purchased your second home for $400,000 and sold it for $500,000, it would initially appear that you profited $100,000 from the sale. But if you also spent $15,000 on acquisition costs, $20,000 to renovate the bathrooms, $25,000 to put on a new roof, and $30,000 in real estate commission, your cost basis may be $490,000. Your profit could actually only be $10,000. In this example scenario, you’ll pay a capital gains tax rate of 15% or $1,500. Depreciate the property if it was used as a rental If you rent out your home, you can typically deduct depreciation on an annual basis. Simply put, depreciation is the tax deduction of the cost to fix, update, maintain, or own a rental property, spread out over the years you own the property. If your second home was rented out while you owned it, you could opt to deduct real estate depreciation for the number of days it was occupied by renters or available to rent each year. As an example, if the property was rented or available to be rented for half of the year, you could claim 50% of the yearly depreciation deduction. Each year, the depreciation would continue to reduce your cost basis. However, keep in mind that if you depreciate your second home, you’ll have to pay another tax called a depreciation recapture, which is a flat 25% of the cumulative depreciation. For example, if you’ve claimed $35,000 in total depreciation, you would likely face an additional $8,750 in taxes when you sell. Rent out your second home You cannot depreciate a vacation home, which is considered personal property. But because it’s a second property, when you sell, it is fully taxable at the capital gains rate as an investment. However, renting out a vacation home is one of the most common ways for a homeowner to mitigate their tax liability on the sale of a second home. In this case, you can typically deduct depreciation and the costs to own, maintain, and rent that property. To use this strategy, you’ll need to start renting out the home long before you list it. It’s also important to note that if you use this strategy to mitigate your capital gains tax, you cannot have used it as a primary residence for the last two of the past five years, and you will very likely have to pay the depreciation recapture tax. It’s strongly encouraged that you consult with a tax and/or real estate professional to map out whether this strategy is available and how it might apply to your situation. Make your second home your primary residence Another way to reduce your tax liability is to turn your second home into your primary residence, which will make you eligible for up to a $500,000 exclusion. According to Brown, every homeowner will most likely exempt the sale of a primary residence within their lifetime. The definition of primary residence is most important when going about making your second home your primary residence. You must have lived in it the majority of the year (more than six months) in any given year for two out of the last five years. “That’s the safe harbor that will get you there. The tests, facts, and circumstances that prove a home is your primary residence include your place of employment, where you have your mail sent, where you bank, and where you go to church,” says Brown. It’s important to note that you can’t use this strategy if you have excluded a capital gains tax on the sale of another property within the past two years.