The rules differ on tax-free exchanges
As popular as tax-free exchanges have become to investors and second-home buyers, some misconceptions remain about how they work.
The Federation of Exchange Accommodators is a national trade organization formed in 1989 to represent those who are directly involved in Section 1031 Exchanges, sometimes known as Starker Exchanges. At the organization’s midyear conference in Washington, D.C., attendees shared common challenges they faced regarding the 1031 Exchange industry. Vacation homes topped the list, even though the Internal Revenue Code is clear on the rules that differentiate a vacation or second home from investment property.
“It seems many taxpayers believe they can exchange a vacation home at any time, and that’s just not the case,” said Tom Oldfield, a Tacoma, Wash., attorney and partner in Olympic Exchange Accommodators, who attended the D.C. conference.
Section 1031 of the IRS code allows a property held for business or investment to be exchanged tax free for another “like kind” property of equal or greater value if the exchange adheres to specific guidelines.
So, is your vacation home an investment property that can be exchanged or a second residence that will face a tax liability if it is sold? It usually comes down to how many personal days you use the property for vacation. If your vacation home is an investment property, the rule is that personal days must not exceed 14 days a year or 10% of rental days, whichever is greater.
“If you want to use the vacation home in a tax-deferred exchange, it must be used as a rental at least for the entire previous year and rented out at fair market value,” Oldfield said.
Homeowners can flip-flop the status of the vacation home each year. For example, let’s say the cabin was used as a second residence in 2006 when you didn’t rent it out at all. However, in 2007 a college professor from the nearby community college rented the place for three academic quarters and the cabin became an investment property, thereby changing the tax status.
If you are planning to execute a 1031 tax-free exchange, make sure your vacation home held investment status for at least the previous year before attempting an exchange. Although there are no absolute rules as to how long the property should be held as an investment, accountants suggest that the property show up as a rental on at least two consecutive tax returns.
The “consecutive” part is vital, Oldfield said. “Some taxpayers have been led to believe that once the cabin has been used as an investment property it can be used in an exchange at any time. If it reverts back to a second home in the year before the exchange, it would . . . not be eligible for the exchange.”
Income derived from renting out a second home or primary residence for 14 days or fewer does not have to be reported to the IRS and does not change the tax status of the home. It’s only when the 14-day limit is exceeded that a change occurs.
Another popular tax strategy, especially for retirees, is to convert the second home to a primary residence. Say a couple retire and sell the longtime family home, pocketing $500,000 tax free from its sale. The couple move to their vacation home, making it their primary residence. Two years later, they can sell the place, move to an apartment and pocket up to $500,000 tax free again because it had become their primary residence.
Vacation homes can definitely help with your financial picture, but make sure you are clear on the status before you attempt to trade or sell.
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Tom Kelly’s book “Cashing In on a Second Home in Mexico” was written with Mitch Creekmore, senior vice president of Houston-based Stewart International.
