Reducing Capital Gains On Your Vacation Home

Prepared by Michael Menninger, CFP | Updated for 2025

Many homeowners also own vacation homes and are sitting on tax time-bombs.  These vacation homes are often located at shore points along the beaches of New Jersey, Delaware, and Maryland.  For those who have owned their properties for a long time, they have likely seen a significant appreciation in the value of their property.  As such, the sale of that property could result in capital gains taxes that can be tens of thousands of dollars, or more.  In this month’s “Tricks of the Trade”, we present three alternatives that can reduce, or even eliminate  capital gains taxes.

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1. Establish Your Vacation Home As Your Primary Residence

Leverage the IRS Home Sale Exclusion Rule

Federal (and most state) laws allow for tax breaks when selling your primary residence.  

• A $250,000 exemption for single filers, or
• A $500,000 exemption for married couples filing jointly

To qualify, you must have lived in the home for at least two of the last five years before selling.

That means a married couple could potentially sell their vacation home and eliminate up to $500,000 in capital gains from taxation — often wiping out the tax burden entirely.

To qualify, you’ll need to prove residency with documents such as:

• Driver’s license or voter registration showing the vacation home’s address
• Utility bills or bank statements in your name at that address

Example strategy

If you plan to sell both your main residence and your vacation property, you could:

1. Sell your current primary home first
2. Move into your vacation home and establish it as your primary residence for two years Then sell it and claim the capital gains exemption

Alternatively, some homeowners move into their vacation home for two years, sell it, and then move back. There are a variety of options depending on your goals and timeline.

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2. Complete a 1031 Exchange

Defer Taxes by Exchanging Properties

A 1031 exchange allows you to sell one property and reinvest the proceeds into another “like-kind” property — deferring the capital gains taxes that would otherwise be due.

This powerful tool can be used when your vacation home is classified as a rental or investment property, but not for purely personal use homes. To qualify, you must:

• Convert your vacation home into a rental property before selling
• Work with a qualified 1031 exchange intermediary
• Identify your replacement property before selling the original
• Purchase the new property within IRS-defined timelines
• Hold sale proceeds in escrow during the transaction

Because 1031 exchanges are highly regulated, every step must be followed carefully — otherwise, the IRS may disallow the tax deferral.

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3. Leave The Property To Heirs  

Utilize the Step-Up in Basis Rule

Under current IRS laws, when an individual passes away, the value of their assets — including real estate — receives a “step-up” in cost basis. That means your heirs inherit the property at its fair market value at the time of your death, effectively eliminating capital gains that occurred during your lifetime.

For example, if you purchased a vacation home for $300,000 and it’s worth $800,000 when you pass away, your heirs inherit it with a basis of $800,000. If they sell it immediately, there’s no taxable gain.

This can be a powerful estate planning strategy — but it’s not always simple. If you need to access the home’s equity or plan to gift the property during your lifetime, different tax consequences apply. When you gift a property, the original cost basis transfers to the new owner and does not receive the step-up in basis.

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Combining Capital Gains Strategies

It’s possible to combine multiple strategies - for example, converting a vacation home to a rental, performing a 1031 exchange, and eventually passing it to heirs.

Because tax law changes frequently, make sure you’re reviewing the most up-to-date information and getting advice tailored to your goals.

Speak With a Qualified Financial Advisor 

As you can see above, there are a multitude of ways in which the owner of a highly appreciated property can legally mitigate capital gains taxes on their property. It is also important to note that a combination of the ideas noted above can also be utilized. Be aware that tax law changes occur frequently, so it is important to be aware that you are getting the most updated information. We strongly encourage you to speak with your qualified financial advisor or tax professional.

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Frequently Asked Questions 

Q1: Can I avoid capital gains tax if I sell my vacation home?

A: Yes, you may reduce or avoid capital gains through strategies like the primary residence exclusion, 1031 exchange, or step-up in basis for heirs.

Q2: How long do I need to live in my vacation home to qualify for the home sale exclusion?

A: You must live in it for at least two of the last five years before selling.

Q3: Can a 1031 exchange be used for personal residences?

A: No. A 1031 exchange only applies to investment or rental properties, not personal-use homes.

Q4: What happens to capital gains taxes when I pass my home to my heirs?

A: Heirs receive a “step-up” in basis, which often eliminates prior capital gains taxes.

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