Vacation Homeowners Now Have Several
As many of us plan our vacations, many vacation home owners wonder if now is a good time to sell their second home and what the tax consequences of that sale might be. For years, we have been asked by owners of vacation homes whether they can exchange these vacation properties. Section 1031 does not define what qualifies as an investment property but section 280A of the tax code does. Investment properties cannot be used by the owner for personal use for more than the greater of 14 days or 10% the number of days rented annually.
If a vacation home is used primarily as a second home with the owner and his/her family using the property well over 14 days annually, the property does not qualify as an investment. Prior to 2007, there were just a few cases to provide guidance on whether or not you could exchange a vacation home and most advisors felt a vacation home did not qualify. However, during the real estate boom in 2004 and 2005, aggressive Taxpayers took the position that all real estate is acquired for future appreciation and therefore, an exchange should work. As a Qualified Intermediary (QI), it is not our call whether or not an exchange can be done but we certainly can raise red flags and we did when it came to vacation homes. We often encouraged owners of vacation homes that wanted to exchange to seek a tax or legal opinion letter from their professional advisor before proceeding.
In 2007, the exchange industry began to get guidance from IRS on the exchange of vacation homes. During that Spring, in Moore v. Commission, T.C. memo (2007-134), IRS ruled against the taxpayer who exchanged one lakefront vacation home for another. The argument that the property, which was never rented, was held with the expectation of profit was unsuccessful. During that Fall, the Office of the Treasury Inspector General of Tax Administration (TIGTA) issued a report stating a need for more oversight of 1031 exchanges. The report advised IRS to provide taxpayers with guidance on the exchange of vacation home and encouraged a study (a/k/a audit) of exchanges. The report targeted those exchanging vacation homes as well as those promoting the exchange of vacation homes such as real estate professionals, attorneys, accountants and QIs.
In early 2008, the IRS provided the long awaited guidance and surprised many within the exchange industry. Revenue Procedure 2008-16 created a “safe harbor” for the exchange of vacation homes if the following criterion was met:
- Must own the relinquished property for at least 24 months prior to the sale;
- Must rent the relinquished property to an unrelated party at a fair market rent for at least 14 days in each of the two twelve month periods prior to the sale;
- Must minimize personal use of the relinquished property to 14 days or 10% the number of days rented, whichever is greater, in each of the two twelve month periods prior to the sale.
- Must rent the replacement property to an unrelated party at a fair market rent for at least 14 days in each of the two twelve month periods after the purchase; and
- Must minimize personal use of the replacement property to 14 days or 10% the number of days rented, whichever is greater, in each of the two twelve month periods after the purchase.
- If you are unable to satisfy these requirements, you must amend your tax return to report the transaction as a taxable sale and not a 1031 exchange.
This new Revenue Procedure provides an excellent opportunity for a vacation home owner who has a significant gain and time to plan. While no one likes to give up personal use of their vacation home, deferring a substantial gain could be well worth the effort.
Another tax deferral strategy that could provide significant benefits when selling a vacation home with significant equity is a structured sale. This strategy provides all of the benefits of an installment sale with the payments guaranteed by a life insurance company. Your sale would be assigned to an assignment company for the insurance company and the buyer comes to closing with all of their money as usual. Your net sale proceeds are forwarded to the assignment company and paid out to you over a period of time. You work with your tax advisor and the assignment company to establish your payout schedule (term, frequency of payments, etc.). A structured sale allows you to establish a payment schedule that works for your needs. The payment schedule will be fixed and you will know the rate of return in advance which enables you to count on the annual income and work with your tax advisor to minimize the tax consequences. For tax purposes, your payments will be treated as follows:
- Return of basis (no tax due);
- Capital gains (paid at capital gain tax rate at time of payment); and
- Earnings (taxed as ordinary income just like any other interest payment).
Structured sales may be a great tax-deferral alternative when a 1031 exchange will not work or the property owner does not want to acquire a replacement property. A few years ago, vacation home owners had limited options when selling but today there are several strategies available to help them preserve their wealth and minimize their tax liability.
For more information on 1031 exchanges or structured sales or to discuss your situation in detail, please contact one of our Certified Exchange Specialists® at 1031help@1031CORP.com or 1.800.828.1031.
Material is provided for informational purposes only. 1031 CORP. cannot provide tax or legal advice. Taxpayers should seek professional tax and/or legal advice for their particular situation.