Section 1031 provides a tax strategy to defer gain when exchanging properties held for investment or use in a trade or business. A personal use property, such as a primary residence or second home, does not qualify, even though everyone would likely agree that all real estate is acquired for future appreciation. Under Section 121, homeowners can qualify for a $250,000 ($500,000, if married filing jointly) exclusion from gain when selling property used as their primary residence for at least 24 of the last 60 months. Unfortunately, vacation homeowners have no easy way out unless they have time and patience to implement a plan.
The exchange of vacation homes was long frowned upon. In 2007, after an unfavorable ruling involving the exchange of a vacation home, the Treasury Department voiced concern that taxpayers were abusing 1031 exchange rules and encouraged IRS to provide guidance. The guidance came in the form of Revenue Procedure 2008-16. Surprisingly, effective March 2008, it offered a “safe harbor” for the 1031 exchange of vacation homes. Generally, a safe harbor means if you follow the rules, the IRS will not attack the transaction. Qualifying for the safe harbor takes time – four years, to be exact.
A summary of the vacation home safe harbor is as follows:
- Taxpayer owns the relinquished property for at least 24 months before selling;
- Taxpayer rents the relinquished property for at least 14 days for each of the two 12-month periods immediately preceding the sale;
- Cannot rent the relinquished property to a related party unless it is a year rental and the related party uses the property as their primary residence; and
- Taxpayer cannot use the property for personal use for more than 14 days or 10% of the number of days the property was rented, whichever is greater.
- Taxpayer must rent the replacement property for at least 14 days for the two 12-month periods immediately following the acquisition;
- Cannot rent to a related party unless it is a year rental and the related party uses the property as their primary residence;
- Taxpayer cannot use the replacement property for personal use for more than 14 days or 10% of the number of days the property was rented, whichever is greater; and
- If taxpayer is unable to satisfy the requirements on the replacement property, he/she must amend his/her return and report the sale of the relinquished property as a taxable sale and not a 1031 exchange.
As with all investment properties, you can still stay at the property while making improvements or for business use reasons without it being considered personal use. Your CPA will likely have some recommendations to document this properly.
For those who purchased their vacation home 10, 20 or even 30 years ago, the idea of selling and paying all of those capital gains is overwhelming. If you could stop using the property for two years (except for 14 days in each of those two years) and rent the property for just 14 days in each of those two years, you will be half way there.
After buying the replacement property, you must minimize your use and rent the property for at least 14 days in each of the first two twelve month periods of ownership. Talk to the property owners around your vacation home and you may even find one who is also interested in exchanging their property under this safe harbor. You can rent their property and they can rent yours!
This strategy creates a great opportunity! Vacation home owners now have the opportunity to defer hundreds of thousands or even millions of dollars of gain on their long held vacation home. When looking at the prize, the four year wait doesn’t seem so tough. Contact someone from of our Exchange Team to discuss your vacation home and put the power of a 1031 exchange to work for you!