Suppose you own a highly valued vacation home that you are ready to unload for some reason. If you just sell it, you could face a huge income tax bill. See my previous column on this unfortunate result. Ugh.

But if you’re still optimistic about real estate and don’t like paying unnecessary taxes, you can instead exchange your vacation home for another vacation home or virtually any other type of property as part of a tax-deferred exchange under Section 1031 of our beloved Internal Revenue Code. Believe it or not, the IRS has provided the recipe for exchanging vacation property tax-free, but it may take you a while to get it working.

I’ll tell you how. But first, some necessary background information.

What is a Section 1031 exchange? Here are the basics

When available, a tax-deferred Section 1031 exchange is a great tool for homeowners. It allows you to offload one property (the abandoned property) and acquire another (the replacement property) without triggering a current tax bill on the appreciation of the abandoned property (the difference between its fair market value and its tax base).

The untaxed gain is transferred to 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 eliminated under current federal income tax rules, thanks to another favorable provision that increases the property’s tax base. a deceased person up to their date of death. assess. Under this agreement, taxable gains can be deferred indefinitely or even eliminated completely if you leave this cruel orb while still owning the property.

Naturally, there are complexities to arranging a successful Section 1031 exchange. I’ve summarized them in this recent column.

One important thing to know is that you may have a taxable gain even on a successful Section 1031 exchange as long as you receive money in the transaction. Ditto if you assume a mortgage on the replacement property lower than the mortgage on the abandoned property which is assumed by the new owner. Worse still, the IRS will treat an exchange that does not meet all of the rules in Section 1031 as a taxable garden variety sale of the abandoned property with the resulting tax hit. Ouch! For these reasons, I recommend getting a tax professional experienced in conducting Section 1031 exchanges before pulling the trigger.

With these thoughts in mind, we are finally ready to talk about the special considerations that apply when exchanging vacation homes.

IRS Approved 1031 Exchange Exercise for Vacation Homes

In Tax Proceeding 2008-16, the IRS opened a “safe harbor” that allows for tax-deferred exchange treatment under Section 1031 for exchanges of vacation properties, including vacation homes.” for mixed use” that you have rented part of the time. and used personally part of the time.

To be eligible for Safe Harbor, you must meet the guidelines explained below for both relinquished property (the vacation property you give up on exchange) and replacement property (the property you receive during the exchange). When you follow these guidelines (along with all other Section 1031 exchange rules), your exchange will qualify for the exempt rule, which means it will automatically pass review with the IRS.

Abandoned Property Guidelines

For the abandoned vacation property, you must pass the following two tests.

1. You must have owned it for at least 24 months immediately prior to the trade-in.

2. During each of the two 12-month periods during the 24 months immediately preceding the exchange: (1) you must have rented the property at market price 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 at market rates.

Replacement Property Guidelines

For the replacement property, which can be virtually any type of real estate, you must pass the following tests.

1. You must continue to own it for at least 24 months after the trade-in and you must own it for rental or business purposes.

2. If the replacement property is another holiday home, you must pass a more complicated test. During each of the two 12-month periods during the 24 months immediately following the exchange: (1) you must rent 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 at market rates.

Example: You own a vacation home worth $1 million.

Say you have a beautiful mixed-use vacation home that’s worth $1 million in today’s overheated market. Your tax base in the property is only $200,000. There is no mortgage.

If you sold the place, you would report a taxable gain of $800,000 ($1 million – $200,000). Not good. But let’s say you want to buy a property that you will rent out or own for investment purposes or another vacation home that will pass the replacement property tests. Good. You can arrange a Section 1031 exchange and avoid any current tax impact.

Suppose you find another property worth $1.1 million that you would like to own. You can exchange your vacation home for the new replacement property and pay $100,000 in cash to equalize the exchange. As long as you follow the aforementioned security guidelines for both properties, you can trade under Section 1031 and avoid any current tax impact. Congratulation. Your tax base in the replacement property is $300,000 ($1.1 million less an $800,000 deferred gain from the abandoned property).

The bottom line

The ability to arrange IRS Section 1031-approved exchanges of an appreciated vacation home is a great tax-saving opportunity, especially if the appreciation is huge, as in the previous example.

While you cannot make a Section 1031 exchange of a vacation home that you used strictly for personal use, all is not lost. You can always prepare for a coming Exchange under Section 1031 by renting the property for enough days over the next 24 months to meet the abandoned property guidelines. Then you can find a suitable replacement property and enter into a Section 1031 agreement.