If you own a highly appreciated vacation home that you’re ready to unload, the sale will generate a significant gain — and a sizable tax bill. However, if you’re still bullish on real estate and don’t need cash right away, there’s a way to minimize the tax hit. Instead of selling the property outright, you could swap your vacation home for another (or virtually any other type of real property) in a tax-deferred like-kind exchange under Section 1031 of the federal tax code.
The IRS has supplied the recipe for this tax-saving strategy, but it may take some time to execute. Here’s how it works.
IRS-Approved Recipe for Vacation Homes
A Sec. 1031 exchange can be a powerful tax-saving tool for real property owners. However, special considerations apply when swapping a vacation home.
In Revenue Procedure 2008-16, the IRS opened a safe harbor that allows tax-deferred Sec. 1031 exchange treatment for swaps of vacation properties. This treatment applies to a “mixed-use” vacation home you’ve rented and used personally.
To be eligible for the safe harbor, you must meet the guidelines for both the relinquished property (the property you give up in the swap) and the replacement property (the property you receive in the swap). When you meet these guidelines and all the other Sec. 1031 exchange rules, your swap will qualify for safe harbor, which means it will automatically pass muster with the IRS.
Relinquished Property Guidelines
The relinquished vacation property must pass two tests:
- You must have owned it for at least 24 months immediately before the exchange.
- Within each of the two 12-month periods during the 24 months immediately preceding the exchange:
- You must have rented out the property at market rates for at least 14 days, and
- Your personal use of the property can’t exceed the greater of 14 days or 10% of the days the property was rented out at market rates.
Replacement Property Guidelines For the replacement property, which can be virtually any kind of real estate, you also must pass two tests:
- You must continue to own it for at least 24 months after the exchange, and
- You must hold it for rental, business, or investment purposes.
If the replacement property is another vacation home, you must pass a more difficult test. Within each of the two 12-month periods during the 24 months immediately after the exchange:
- You must rent out the property at market rates for at least 14 days, and
- Your personal use of the property can’t exceed 14 days or 10% of the days the property is rented out at market rates.
Hypothetical Example
Suppose you have a mixed-use beachfront vacation home worth $1.1 million in today’s market. Your tax basis on the property is only $300,000 because you bought it years ago. There’s no mortgage. If you sold the property, you would have to report an $800,000 taxable gain ($1.1 million minus $300,000).
However, let’s say you want to acquire real property that you’ll rent out, hold for investment, or use as another vacation home that will pass the replacement property tests. In these cases, you could arrange a Sec. 1031 exchange and avoid any current tax hit.
Fortunately, you find another property worth $1.5 million. That means you can swap your vacation home for the new replacement property and throw in $400,000 cash to equalize the trade. As long as you pass the safe-harbor guidelines for both properties, you’ll qualify for a Sec. 1031 exchange and avoid any current income tax hit.
What’s your tax basis for the replacement property? It’s $700,000 ($1.5 million minus the $800,000 gain you rolled over from the relinquished property).
For More Information
The ability to arrange IRS-approved Sec. 1031 swaps of an appreciated vacation home is a tremendous tax-saving opportunity. If you can’t make a Sec. 1031 exchange of a vacation home you’ve used strictly for personal purposes, all is recovered. You can still set yourself up for a future Sec. 1031 exchange by renting the property out for enough days over the next 24 months to meet the relinquished property safe-harbor guidelines. Then you can find a suitable replacement property and arrange a Section 1031 exchange. Contact a Reynolds + Rowella tax advisor for more information on this subject.
Reynolds + Rowella is a regional accounting and consulting firm known for a team approach to financial problem solving. As Certified Public Accountants, our partners foster a personal touch with our clients. As members of DFK International/USA, an association of accountants and advisors, our professional network is international, yet many of our clients have known us for years through the local communities we serve. Our mission is to operate as a financial services firm of outstanding quality. Our efforts are directed at serving our clients in the most efficient and responsive manner possible, delivering services that exceed the expectations of those we serve. The firm has offices at 90 Grove St., Ridgefield, Conn., and 51 Locust Ave., New Canaan, Conn. For more information, please contact Elizabeth Bresnan at 203.438.0161 or email.
