If you own a highly appreciated vacation home that you’re ready to unload, the sale will generate a large 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 instead swap your vacation home for another vacation home (or virtually any other type of real property) in a tax-deferred like-kind exchange under Section 1031 of the federal tax code.
Section 1031 Real Estate Exchange Basics
When available, a tax-deferred Section 1031 like-kind exchange is a great tool for real estate owners. It allows you to unload one property (the relinquished property) and acquire another one (the replacement property) without triggering a current federal income tax bill on the relinquished property’s appreciation. The deferred gain (the difference between its fair market value and its tax basis) is rolled over into the replacement property where it remains untaxed until you sell the replacement property in a taxable transaction. (See main article for further details.)
However, if you still own the property when you die, any taxable gain may be completely washed away under the current federal income tax rules. That’s because another favorable provision “steps up” the tax basis of a deceased person’s property to its date-of-death value. Under this deal, taxable gains can be eliminated altogether.
Important: You can have a taxable gain even with a successful Sec. 1031 exchange to the extent you receive cash in the deal — or if you assume a mortgage on the replacement property that’s smaller than the mortgage on the relinquished property that’s assumed by the new owner. Worse yet, the IRS will treat an exchange that fails to meet all the Sec. 1031 rules as a garden-variety taxable sale of the relinquished property with the resulting tax hit.
To avoid potential pitfalls, it’s critical to hire a tax professional who’s experienced in conducting Sec. 1031 exchanges before attempting to execute this tax-saving strategy.
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. (See “Section 1031 Real Estate Exchange Basics” at right.) 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 even applies to a “mixed-use” vacation home that you’ve rented out and used personally.
To be eligible for the safe harbor, you must meet the guidelines for both the relinquished property (the property that you give up in the swap) and the replacement property (the property that you receive in the swap). When you meet these guidelines, along with all the other Sec. 1031 exchange rules, your swap will qualify for the safe harbor, which means it will automatically pass muster with the IRS.
Relinquished Property Guidelines
The relinquished vacation property must pass two tests:
1. You must have owned it for at least 24 months immediately before the exchange.
2. 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 have exceeded 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:
1. You must continue to own it for at least 24 months after the exchange, and
2. You must hold it for rental, business or investment purposes.
If the replacement property is another vacation home, you must also pass a more complicated 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 the greater of 14 days or 10% of the days the property is rented out at market rates.
Suppose you have a mixed-use beachfront vacation home that’s worth $1.1 million in today’s market. Your tax basis in 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 thereby avoid any current income tax hit.
What’s your tax basis in the replacement property? It’s $700,000 ($1.5 million minus the $800,000 gain that 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 great tax-saving opportunity. If you can’t make a Sec. 1031 exchange of a vacation home that you’ve used strictly for personal purposes, all isn’t lost. 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 your tax advisor for more information on this subject.