Intro

WANT TO UNLOAD

your vacation home? If you reside in the place part of the time and rent it out when you aren't there, you should think twice before selling.

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.

Section 1031 Exchange 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).

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.

New IRS-Approved Safe Harbor for Vacation Home Swaps

In Revenue Procedure 2008-16, the IRS opened up a new "safe harbor" that allows tax-deferred Section 1031 exchange treatment for swaps of mixed-use vacation properties. To be eligible, however, you must meet the guidelines for both the relinquished property and the replacement property (see guidelines below). Meet these criteria (along with all the other Section 1031 exchange rules) and your swap will pass muster with the IRS.

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.

What Counts as Personal Use?

Too many personal-use days for either the relinquished property or the replacement property can make you ineligible for the safe harbor. So what counts as personal use? According to the IRS, you have a personal-use day on your hands whenever your property is used for any part of that day in any of the following ways:

1. For personal purposes by you or by anyone else who has an ownership interest in the property.

2. By a member of your family or by a member of the family of anyone else who has an ownership interest in the property.

3. By anyone under an arrangement that allows you to use another property (whether or not you pay market rent for using that other property).

4. By anyone who pays less than market rent.

One exception: If someone (including a member of your family) uses your property as a principal residence, it doesn't count as personal use as long as that person pays you market rent.

Example

: Say you have a mixed-use vacation home worth $600,000. It has a tax basis of only $200,000 and no mortgage. Selling it would result in a $400,000 taxable gain ($600,000 - $200,000). However, if you want to acquire another vacation home, you could try for a Section 1031 exchange under the new safe-harbor provision. Say you find another vacation home worth $700,000. You could swap your existing property for the new one and throw in $100,000 cash to equalize the trade. As long as you meet the usage guidelines for both properties, you will successfully pull off a tax-deferred Section 1031 exchange, thereby avoiding any current income tax hit. Your tax basis in the new property will be $300,000 ($700,000 - $400,000 gain rolled over from the old property).

The Bottom Line

The new safe harbor is open for exchanges of mixed-use vacation properties that occur on or after March 10, 2008. For earlier swaps, it's debatable whether tax-deferred Section 1031 treatment is allowed or not. It's also unclear how to figure out the proper tax treatment for an exchange when the safe-harbor guidelines are not exactly met (for example, because you rented out the relinquished property for substantial periods, but had a few more personal-use days than allowed).

Last but not least, you cannot get tax-deferred Section 1031 exchange treatment for a vacation home that you've used strictly for personal purposes. However, 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.

Also See:

• 5 Ways to Negotiate a Better Deal on a Home

• 3 Factors That Reduce a Home's Value

• Taxes on Vacation Homes