If you have been considering selling a vacation home that you rent out and use for yourself too, and you’re (justifiably) leery of incurring a big tax hit, a recent move—IRS Revenue Procedure 2008-16 that extends tax-deferred Section 1031 exchange treatment for mixed use vacation property swaps— may give you a way out. Here’s an overview of how this newly announced change might work to your advantage, if you are willing to swap out your original property to acquire a new vacation property. As always, it’s smart to consult with your tax professional to determine if a 1031 Exchange would be the best way for you to minimize your tax bill.
Despite a general slump in residential real estate prices, some vacation properties are valued at far more than the tax basis in the property. The tax basis is generally calculated as the purchase price, plus renovation costs, minus any deprecation deductions claimed for rental periods. Selling your vacation home now under such conditions could leave you with a hefty bill for the taxable gain.
A Possible Solution
In the past, a tax-deferred Section 1031 exchange— which allows owners to sell a property and acquire another one without generating a current income tax bill on the relinquished property’s appreciation—didn’t apply to vacation homes rented out for part of the year. Now, under Revenue Procedure 2008-16, this has changed and mixed use vacation properties (i.e. ones you both use and rent) may be eligible for swaps for other mixed-use vacation properties.
In order to take advantage of this expansion of the Section 1031, you have to meet not only the basic eligibility requirements applied to Section 1031 exchanges but also the specific requirements regarding the terms of your ownership of the vacation property.
Section 1031 exchange requirements are complex. To make sure you don’t fall foul of IRS eligibility requirements consult with your professional tax advisor. As an added plus, eligible 1031 exchanges are not limited to one “swap”, and – as things currently stand—there is nothing to prevent an owner rolling over untaxed gains into further property exchanges. However, if you make any cash profit in a “swap”, you may have to pay taxes on the profit.
Considerations Specific to Vacation Properties
For vacation property, in addition to the “basic” requirements you must meet to make you eligible for the tax break, there are additional vacation home eligibility requirements for the relinquished and the newly acquired property, including:
- For the original property:
- Owning it for at least 24 months prior to the exchange;
- Renting out the property within each 12 month period during the 24 months preceding the exchange for at least 14 days, and show personal use of the property that did not exceed 14 days or 10 percent of the time it was rented out at market rates;
- For the replacement property:
- Continue to own it for the 24 months that follow the exchange
- Follow the same occupy/rent ratios as outlined for the original property.
Be aware that, in order to qualify for the tax breaks involved in an exchange (as defined by Section 1031), the property must be a dwelling unit that has basic accommodations including sleeping space, bathroom and cooking facilities. Also, if your periods of residence exceed the guidelines outlined above, you won’t qualify for the exchange tax breaks. Personal use includes use by family members and anyone who stays in your property at less than market rent. Exceptions may be made if the family member uses your property as a primary residence and pays market rent to you.