Say you own a highly-appreciated vacation home that you’re ready to unload for whatever reason. If you simply sell it, you could face a whopping big income tax bill. See my earlier column on that unfortunate outcome. Ugh.
But if you’re still bullish on real estate and not a fan of paying taxes unnecessarily, you could instead swap your vacation home for another vacation home or virtually any other type of real property in a tax-deferred exchange under Section 1031 of our beloved Internal Revenue Code. Believe it or not, the IRS has supplied the recipe for how to exchange a vacation property tax-free, but it may take you some time to make it work.
I’ll tell you how to do it. But first, some necessary background information.
What is a Section 1031 exchange? Here are the basics
When available, a tax-deferred Section 1031 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 income tax bill on the relinquished property’s appreciation (the difference between its fair market value and its tax basis).
The untaxed gain gets rolled over into the replacement property where it remains untaxed until you sell the replacement property in a taxable transaction. But if you still own the property when you die, any taxable gain may be completely washed away under the current federal income tax rules, thanks to another favorable provision that steps up the tax basis of a deceased person’s property to its date-of-death value. Under this deal, taxable gains can be postponed indefinitely, or even eliminated altogether if you depart this cruel orb while still owning the property.
Naturally, there are intricacies to arranging a successful Section 1031 exchange. I summarized them in this recent column.
One important thing to know is that you can have a taxable gain even on a successful Section 1031 exchange to the extent you receive cash in the deal. Ditto if you assume a mortgage on the replacement property that is smaller than the mortgage on the relinquished property that is assumed by the new owner. Worse yet, the IRS will treat an exchange that fails to meet all the Section 1031 rules as a garden-variety taxable sale of the relinquished property with the resulting tax hit. Ouch! For these reasons, I recommend hiring a tax pro who is experienced in conducting Section 1031 exchanges before pulling the trigger.
With those thoughts in mind, we are finally ready to talk about special considerations that apply when swapping vacation homes.
IRS-approved 1031 exchange drill for vacation homes
In Revenue Procedure 2008-16, the IRS opened up a “safe-harbor” that allows tax-deferred Section 1031 exchange treatment for swaps of vacation properties, including “mixed-use” vacation homes that you’ve rented out part of the time and used personally part of the time.
To be eligible for the safe-harbor, you must meet the guidelines explained below for both the relinquished property (the vacation 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 Section 1031 exchange rules), your swap will qualify for the safe harbor, which means it will automatically pass muster with the IRS.
Relinquished property guidelines
For the relinquished vacation property, you must pass both of the following 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: (1) you must have rented out the property at market rates for at least 14 days and (2) your personal use of the property cannot 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 must pass the following tests.
1. You must continue to own it for at least 24 months after the exchange, and you must hold it for rental or business purposes.
2. If the replacement property is another vacation home, you must pass a more complicated test. Within each of the two 12-month periods during the 24 months immediately after the exchange: (1) you must rent out the property at market rates for at least 14 days and (2) your personal use of the property cannot exceed the greater of 14 days or 10% of the days the property is rented out at market rates.
Example: You own a vacation home worth $1 million
Say you have a nice mixed-use vacation home that’s worth a cool $1 million in today’s overheated market. Your tax basis in the property is only $200,000. There’s no mortgage.
If you sold the place, you would have to report an $800,000 taxable gain ($1 million – $200,000). Not good. But say you want to acquire real property that you will rent out or hold for investment or another vacation home that will pass the replacement property tests. Good. You could arrange a Section 1031 exchange and avoid any current tax hit.
Say you find another property worth $1.1 million that you would love to own. You can swap your vacation home for the new replacement property and throw in $100,000 cash to equalize the trade. As long as you pass the aforementioned safe-harbor guidelines for both properties, you can pull off a Section 1031 exchange and thereby avoid any current income tax hit. Congrats. Your tax basis in the replacement property is $300,000 ($1.1 million minus $800,000 gain rolled over from the relinquished property).
The bottom line
The ability to arrange IRS-approved Section 1031 swaps of an appreciated vacation home is a great tax-saving opportunity, especially if the appreciation is whopping, as in the preceding example.
While you can’t make a Section 1031 exchange of a vacation home that you’ve used strictly for personal purposes, all is not lost. You can still set yourself up for a future Section 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 do a Section 1031 deal.