02/02/10: Exchanging Vacation Homes
By Benny L. Kass
Tax reform is taking the taxes off things that have been taxed in the Past and putting taxes on things that haven’t been taxed before.
You own property in Rehobeth, Delaware – called “our nation’s summer capitol”. It has appreciated greatly over the years, but now you want to sell it. You have heard that you can defer any capital gains by doing a Starker exchange under Section 1031 of the Internal Revenue Code.
How do you go about this?
In order to have a valid Starker Exchange, only investment properties can be swapped with other investment properties. You cannot do an exchange with your principal residence.
When discussing the 1031 exchange, it is important to use the proper terminology. The property that you currently own and want to dispose of is called the “relinquished property”. The new property that you want to obtain by way of the exchange is the “replacement property”.
To qualify the relinquished vacation or second home for the exchange, it must have been owned by the taxpayer for at least 24 months immediately before the exchange. (The IRS refers this as the “qualifying use period”.)
Additionally, for each of the two years within the qualifying use period, the taxpayer must have rented the property at a fair rental for at least 14 days. The taxpayer cannot have used it personally for the greater of 14 days or 10 percent of the number of days during each 12-month period that the property is rented at a fair rental.
Sounds confusing, but it is the law. The IRS does not want taxpayers to claim that their property is “investment” when in fact they take their families to the beach for the entire summer, or even a significant part of the summer.
These requirements have been upheld by the Tax Court, a court that handles a number of taxpayer disputes with the IRS. In one case, the taxpayer exchanged one lakeside property for another. Neither home was rented out, and both were used by the taxpayer exclusively for personal purposes. The taxpayer argued that he knew the properties would appreciate and thus held them for investment purposes. But the tax court disagreed, stating that “the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.”
You can, of course, periodically go to your second home to inspect it, and make any necessary repairs. However, if that use exceeds the use restrictions described above, you will not be able to do a Starker exchange. Confirm this with your own accountant.
What is fair rental? The IRS relies on its standard formula: it will look to the facts and circumstances of each case. To be on the safe side, have at least two real estate agents provide you with a written market analysis of the rents being charged for similar properties in the area where both the relinquished and the replacement properties are located.
What about the replacement property? Here, the same rules apply. If you swap one property for another, you must rent it out for at least two years, or the exchange will fail. According to the IRS:
If a taxpayer files a federal income tax return and reports a transaction as an exchange under §1031, based on the expectation that a dwelling unit will meet the qualifying use standards … and subsequently determines that the dwelling unit does not meet (those) standards, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange…
That could create a financial disaster for you and your checkbook. You did a 1031 exchange, and per the rules, you have to use all of the proceeds from the sale of the relinquished property in order to obtain the replacement property. Now, you have failed to comply with the requirements and have to file an amended return – and pay the tax on the capital gain. Where will you get the money to do this?
If you follow the rules, a 1031 exchange can be a very valuable tool. For example, if you purchased your investment property for $150,000, and sold it for $500,000, you would in most cases have to pay the IRS $52,500 (based on the current capital gains rate of 15 percent), in addition to any State or Local tax. However, if this property was sold in connection with a Starker exchange, and you obtained another investment property worth at least $500,000, you would not have to pay any capital gains tax. Instead, the basis of the old property would be transferred to the new one; you would only have to pay the tax when you ultimately sold the replacement property and did not engage in yet another 1031 exchange.
Keep in mind that a Starker (1031) exchange is not a “tax free” process, contrary to what you may have heard. It is only a way of deferring any tax that you would have paid had you just sold – and not exchanged – that property.
And even if you follow the vacation rules spelled out by the IRS, you still have to comply with the general requirements of a like-kind exchange. While you must consult your tax and legal advisors about your specific situation, here is a brief synopsis.,
You must identify the replacement property within 45 days after you have gone to settlement on the relinquished property,. The identification must be as specific as possible. You can identify up to three such replacement properties. However, if you want to identify more, the aggregate fair market value of the identified properties cannot exceed 200 percent of the aggregate value of the relinquished property (or properties). And the replacement property must be one that you have identified.
The price of the replacement property must be at least equal to the sales price of the relinquished property. All of the sales proceeds from the relinquished property must be held in escrow by a qualified intermediary – an independent third party; under no circumstances can you have any access to that money. It must all go into the purchase of the replacement property.
And finally, you must acquire the new property within 180 days from the day you disposed of the relinquished property. If your tax return comes due before the 180 day period, you either have to close on the new property or get the automatic extension.
The rules are complex, and must be followed religiously. To the casual observer, it still looks like you have sold one property and bought another. And although in reality it is “form over substance”, the IRS will challenge – and often successfully – any exchange that does not comply strictly to their rules.