How To Avoid Taxes On The Sale Of A Vacation Home
As real estate prices recover, many vacation properties are once again worth far more than their tax basis (generally the purchase price plus the cost of improvements minus any depreciation deductions you’ve claimed for rental periods). As a result, if you’re looking to sell a vacation home and use the proceeds to buy another one, there could be a big tax hit. But you can avoid it if you swap your vacation home for another in a tax-deferred exchange — as long as it’s a home you’ve rented out most of the time and used as your personal residence some of the time. In fact, the government has supplied the recipe for how to exchange mixed-use vacation properties.
Here’s what you need to know.
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).
The untaxed gain gets rolled over into the replacement property where it remains untaxed until you sell the replacement property in a taxable transaction. But if you still own the property when you die, any taxable gain may be completely washed away thanks to another favorable rule that steps up the tax basis of a decedent’s property to its date-of-death value. So taxable gains can be postponed indefinitely, or even eliminated altogether if you die while still owning the property. Real estate fortunes have been made in this fashion without sharing much with Uncle Sam.
Naturally, there are intricacies to arranging a successful Section 1031 exchange. I’m not going to cover them here, because I don’t want this to turn into a book. That said, you need to understand that you can have a taxable gain even on a successful Section 1031 exchange to the extent you receive cash in the deal. Ditto if you assume a mortgage on the replacement property that is smaller than the mortgage on the relinquished property that is assumed by the new owner. Worse yet, the IRS will treat an exchange that fails to meet all the Section 1031 rules as a garden-variety taxable sale of the relinquished property with the resulting tax hit. Ouch! For these reasons, I recommend hiring a tax pro who is experienced in conducting Section 1031 exchanges before pulling the trigger.
With those thoughts in mind, we are finally ready to talk about special considerations that apply when swapping mixed-use vacation homes.
IRS-Approved Safe Harbor: In Revenue Procedure 2008-16, the IRS opened up a “safe-harbor” that allows tax-deferred Section 1031 exchange treatment for swaps of mixed-use vacation properties. To be eligible for the safe-harbor, you must meet the guidelines explained below for both the relinquished property (the property you give up in the swap) and the replacement property (the property you receive). When you meet these guidelines (along with all the other Section 1031 exchange rules), your swap will qualify for the safe harbor, which means it will automatically pass muster with the IRS.
Relinquished Property Guidelines:
For the relinquished property, you must pass both of the following tests.
You must have owned it for at least 24 months immediately before the exchange.
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 cannot have exceeded the greater of 14 days or 10% of the days the property was rented out at market rates.
Replacement Property Guidelines:
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.
Here’s an Example
Say you have a mixed-use vacation home that’s worth $600,000. It has a tax basis of only $200,000 and no mortgage. If you sold it, you would have to report a $400,000 taxable gain ($600,000 – $200,000) on Form 1040. Yikes! However, if you want to acquire another vacation home, you could arrange a Section 1031 exchange. Say you find another home worth $700,000 that you would love to own. So you swap your old vacation home (the relinquished property) for the new one (the replacement property) and throw in $100,000 cash to equalize the trade. As long as you meet the aforementioned usage guidelines for both properties, you can pull off a tax-deferred Section 1031 exchange and thereby avoid any current income tax hit. Congrats! Your tax basis in the replacement property is $300,000 ($700,000 – $400,000 gain rolled over from the relinquished property).
The Bottom Line
The ability to arrange IRS-approved Section 1031 swaps of appreciated vacation homes is a great tax-saving opportunity. However, you cannot make a Section 1031 exchange of a vacation home that you’ve used strictly for personal purposes. That said, you can 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.