Exchanging Vacation Homes
Exchanging Vacation Homes
Most real estate investors are aware that Section 1031 of the Internal Revenue Service Code provides for tax deferred exchanges of real property held for investment. Section 1031 of the IRS code currently provides that
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or a business or for investment.”
The basic rule is that the relinquished (old) properties and the replacement (new) properties must be of “like kind,” with “like kind” being defined very broadly. A duplex can be exchanged for vacant land and a shopping center can be exchanged for oil wells or timber land.
Furthermore, property held for productive use in a trade or business may be exchanged for property held for investment, and property held for investment may be exchanged for property held for productive use in a trade or business.
Another basic rule is that “you can’t touch the money between the sale of your old property and the purchase of your new property.” Any funds or other items of value received, even temporarily, by the exchanger become “boot” and are subject to taxation. Accordingly, the IRS Code requires that an independent third party, called a Qualified Intermediary (QI), be involved in handling the transaction except in the very limited case of a simultaneous exchange.
Rules, upheld by court decisions, specify that gain or loss from an exchange of personal residences may not be deferred under Section1031 because the residences are not property held for productive use in a trade or business or for investment. The Tax Court has held that a personal residence property is held for personal use and that the “mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.”
In spite of the Tax Court decision, the Service recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. This property is often called a vacation home.
The IRS Code lays out in detail the procedures for turning a sale and purchase type transaction into an exchange. This article briefly discusses the narrow topic of some basic principles regarding exchanging a vacation home or any other property which the taxpayer only occasionally uses as a dwelling. The detailed rules of exchanging will not be discussed in this article.
The IRS provides taxpayers with a safe harbor procedure under which the Service will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of Section 1031 even though the taxpayer occasionally uses the dwelling unit for personal purposes. Among requirements are both a minimum period of bona fide rental operation and a maximum period of use by the owner.
The basic requirements regarding the old property are as follows:
- The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the “qualifying use period”) and
- Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange:
- The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
- The period of the taxpayer’s personal use of the new dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
- For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).
The basic requirements of the dwelling unit that a taxpayer intends to be the new property in a Section 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:
- The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”) and
- Within the qualifying use period, in each of the two 12-month periods immediately after the exchange:
- The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
- The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
- The first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.
Personal use of a dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes. Time spent at the property while performing necessary repairs and maintenance may not have to be counted as time spent in residence.
Whether a dwelling unit is rented at a fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the parties to the rental agreement are taken into account.
The safe harbor rules provided applies only to the determination of whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031. A taxpayer utilizing the safe harbor in this revenue procedure also must satisfy all other requirements for a like-kind exchange and the regulations thereunder.
It is important to understand that Section 1031 provides a means of only deferring tax, not a means of tax forgiveness. The basis of the old property becomes the basis of the new property, where basis is most simply defined as:
Basis = Original purchase price + Amortizable purchase costs – Deductible purchase costs + Amortizable costs added to basis after purchase + Depreciable costs added to basis after purchase – Depreciation taken – Amortization taken
Deferral in itself has intrinsic advantages. First, it allows one to transfer significantly more equity of the old property into equity of a new property than would usually be possible if one sold the old property, paid tax on the gain and depreciation recapture, and invested the remainder into a new property. We say “most” of the equity because an exchange usually requires expenditures that would not be required for a sale and purchase. However, as these extra costs of exchanging are relatively small compared to the income tax due for a sale, an exchange is often extremely beneficial.
Even when the investor has to eventually pay the deferred taxes upon future sale of the property, the tax will be paid with inflated dollars, an advantage assuming that tax rates at time of exchange and at the time of eventual sale are similar.
The final exchanged property owned by the investor at the time of his death escapes income taxation because it passes to heirs with a “stepped-up” basis equal to the value at the time of death. Of course, for larger estates, those exceeding the exemption amount provided in the year of death, the government may get something from the estate (death) tax.
Summary
Within the specific boundaries of IRS rules, vacation homes may qualify for deferral of income tax. However, the above discussion should not be considered as tax advice. Readers are strongly advised to consult a competent experienced tax professional when considering Section 1031 transactions.