Swapping Vacation Homes in a Tax-Deferred Exchange

Even though the real estate market is in the dumps, many vacation properties are still valued at far more than tax basis (generally the purchase price plus the cost of improvements, minus any depreciation deductions claimed for rental periods). If your beach bungalow fits the description, then selling it could trigger a whopping taxable gain (the difference between the sale price and your tax basis in the property).

Instead of selling (and getting that unwelcome tax hit), consider swapping your vacation home for another in a tax-deferred exchange under Section 1031 of the Internal Revenue Code. Until very recently, it was unclear whether a vacation home — even one you rent out a lot — could qualify for 1031 tax-deferred treatment, which only applies to swaps of investment or business property. So most guys like me would have advised against treating a swap of a mixed-use vacation property (one that's rented out part of the time and also used for the owner's personal purposes) as a tax-deferred 1031 exchange.

That was then. This is now. In an unexpected development, the government recently handed us the recipe for how to arrange for IRS-approved Section 1031 exchanges. Here's how to take advantage of this taxpayer-friendly news.

Following a Section 1031 exchange, you must roll over any untaxed gains into the replacement property. Those gains will remain untaxed until you unload the replacement property in a taxable transaction. However, nothing prevents you from arranging for yet another tax-deferred exchange. If you still own the property when you die, any taxable gain may be completely wiped out thanks to another favorable rule that steps up the tax basis of a decedent's properties to their date-of-death values. Taxable gains can be postponed indefinitely, or even eliminated altogether, if a person dies with his real-estate-owning boots still on. Fortunes have been made in this fashion without sharing much with Uncle Sam.

Naturally, there are many intricacies involved in a successful Section 1031 exchange — far too many to get into now. That said, it's important to understand that you can have a taxable gain — even on a successful Section 1031 exchange — if you receive cash in the deal. Ditto if you assume a mortgage on the replacement property that's smaller than the mortgage assumed by the new owner of the relinquished property. Worse yet, the IRS will treat an exchange that fails to meet all the Section 1031 rules as a garden-variety sale, complete with the resulting tax hit. For these reasons, I recommend hiring a tax pro who knows the ins and outs of Section 1031 exchanges.

Here are some things to consider when swapping vacation homes.

Property Guidelines

For relinquished property, you must pass both of the following tests.

First Test: You must have owned it for at least 24 months immediately before the exchange.

Second Test: 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 could not have exceeded the greater of 14 days or 10% of the days the property was rented out at market rates.

For the replacement property, you must pass both of the following tests.

First Test: You must continue to own it for at least 24 months immediately after the exchange.

Second 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.

Warning: To be eligible for the new safe harbor, your vacation property must be a dwelling unit — which means a house, an apartment, a condominium, or a similar structure that provides basic living accommodations, including sleeping space and bathroom and cooking facilities.