Sale of second home could trigger big tax bill

Most people who sell their full-time residence can keep all of their profit tax free, but the Internal Revenue Service does not extend the same tax privileges to those who sell a second or vacation home.

Q. We have owned a small vacation home for several years, and now we would like to sell it. How would our resale profits be taxed?

A. You could be facing a big tax bill, unless you have some flexibility in your future plans.

Most people know that when they sell their primary residence, they can keep up to $500,000 of the profits tax free if they file their tax return jointly (it's $250,000 for single filers), provided that they have lived full time in the house for at least 24 months in the past five years.

Unfortunately, the Internal Revenue Service doesn't provide the same break to sellers of vacation homes. Instead, your resale profits will likely be taxed at the long-term capital gains rate of up to 15 percent. You also will owe state income taxes on the profit unless you live in one of the handful of states that doesn't charge them.

There's more: If you rented out the vacation home when you weren't using it and then took depreciation deductions to lower your annual tax bill, those previous deductions may be subject to a maximum 25 percent tax when you sell. This IRS "recapture rule" catches many sellers off-guard and typically costs them thousands of dollars in additional taxes.

There may be a few ways to reduce your tax bite, but their viability primarily depends on your future plans.

One option would be to sell your primary residence instead, and then move into your smaller vacation home. You could keep up to $500,000 tax free from the sale of your personal residence now, and then up to another $500,000 tax free if the vacation home becomes your primary home for at least two years before its future sale. This can be a particularly good strategy for older people who expect to retire soon and no longer need a large house, or for younger people who can work from home instead of commuting to their jobs everyday.

If you're instead planning to buy another vacation home after you sell your current one, you might be able to qualify for an IRS 1031 exchange. This would allow you to take all your profits from the sale and use it to purchase your next vacation property, while at the same time deferring taxes on your profits for several more years.

You could even consider donating your vacation home to a bona fide charity, which would allow you to take a fat write-off based on its current market value. This can be an especially good move for people who are in a high income-tax bracket and need lots of deductions.

Tax laws are tricky, so make sure you consult with a certified public accountant or similar tax professional before you put your vacation home up for sale.

Q. A home for sale in my area includes a phrase in its advertisement that the property is an "unbalanced improvement." What does this mean?

A. Wow, I haven't heard that term in several years.

An unbalanced improvement is a house or other building that does not serve what appraisers call the "highest and best use" of the land itself. For example, if you own a single-family home on a lot that's zoned for an office building, your house would be considered an unbalanced improvement because an office tower is usually worth much more than a house.

Instead of advertising such properties as an "unbalanced improvement," most real estate agents refer to them now as "underused" parcels.

Q. I signed a one-year lease for an apartment in a large development in February. The lease states that all of my unit's utility bills "will be paid by the landlord," but now I have received a certified letter from the landlord stating that my rent will immediately go up by $50 per month "due to the sharp increases in energy and other utility prices." Is this legal?

A. Probably not. Most one-year lease agreements cannot unilaterally be altered by either party until the contract expires. This means that the landlord can't raise your rent by $50 to pay for the unexpected spike in energy prices, just as you wouldn't have the right to demand a $50 reduction if gas or other utility costs suddenly fell.

However, there's a catch: Many rental contracts call for the property owner to pay for "typical" or "ordinary" utility usage for the household's size but also allow the landlord to pass any overuse charges directly to the tenant. If the average utility bills for a two-bedroom apartment in your complex cost the landlord $120 but your monthly bills are $170 because you leave the lights turned on all night or take extra-long showers, the owner may be well within his rights to charge you for the excessive use.

Reread the lease contract you signed in February, and then call your local rent board or rent-control agency if you still have questions.

• For a copy of the booklet "Straight Talk About Living Trusts," send $4 and a self-addressed, stamped envelope to David Myers/Trust, P.O. Box 2960, Culver City CA 90231-2960