BEACON
EXCHANGE
COMPANY
Integrity.
Expertise.
Service.
SECOND
HOMES
AND
VACATION
PROPERTIES
About Beacon
Exchange Company
About Section 1031 Exchanges
Real
Estate Exchanges
-Like Kind Requirement
-Principal Residences
-Second Homes
Personal Property Exchanges
Aircraft Exchanges
Section 1031 Library
Section 1031 like-kind exchanges are available for
qualifying Real
Property that is ‘used in a trade or
business or held for investment.’ Vacation or second homes may or may not
qualify under this definition depending on the specific facts and circumstances
applicable to the taxpayer’s use of his or her vacation home. Frequently, one
of these three categories will apply:
1. Exclusive Personal Use
Vacation or second homes with substantial personal use and never
rented out by the taxpayer are considered by the IRS to be a
‘residence’ and therefore do not qualify as property that is ‘used
in a trade or business or held for investment'. Such vacation homes
are not eligible for a Section 1031
exchange. Moreover, since such homes are not the principal
residence of the taxpayer, they do not qualify for the
Section 121 principal
residence exclusion when sold. As a result, every dollar of
gain on the sale of these homes is subject to tax.
In
Moore v.
Commissioner, a 1031 exchange was disallowed by the tax
court because both the Relinquished and the Replacement
Properties were used extensively by the taxpayers as second homes.
2. Exclusive Rental Use
Vacation or second homes that are used exclusively for rental use (and not for personal purposes) by the taxpayer should qualify as investment property and therefore would be eligible for a like-kind exchange.
According to IRS regulation § 1.1031(a)-1(b), unproductive real estate held by a taxpayer other than a dealer for future use or appreciation is considered ‘held for investment.’ This indicates that renting a property to others is not required for a property owner to meet the required ‘trade, business, or investment’ standard, provided that personal use of the property is limited.
3. Personal and Rental Use
Some vacation or second homes have a dual use - they are used
personally by the taxpayer for part of the year and rented out for
part of the year. Such homes may qualify as an investment property
depending on the specific facts and circumstances relating to the
property’s use by its owner.
In February, 2008, the IRS issued Revenue Procedure 2008-16, which is effective for exchanges occurring on or after March 10, 2008. Rev. Proc. 2008-16 establishes a ‘safe harbor’ under which the IRS will not challenge whether or not a dwelling unit qualifies as a property that is ‘used in a trade or business, or held for investment’, and thus qualify for a Section 1031 exchange. To meet the safe harbor guidelines, the ‘Relinquished’ property must meet these requirements:
a. The property must be owned by the taxpayer for at least 24 months immediately prior to the exchange; and
b. In each of the two 12-month periods prior to the beginning of the exchange, the taxpayer must have rented the property to another person for 14 days or more at a rental equal to its fair market value; and
c. In each of the two 12-month periods prior to the exchange, the taxpayer’s personal use of the property must not exceed the greater of (i) 14 days; or (ii) ten percent of the number of days the property is rented at its fair market value.
The ‘Replacement’ property in the exchange must meet similar requirements in order to meet the safe harbor requirements of Rev. Proc. 2008-16:
a. The property must be owned by the taxpayer for at least 24 months immediately following the exchange; and
b. In each of the two 12-month periods immediately after the exchange, the taxpayer must rent the property to another person for 14 days or more at its fair market value; and
c. In each of the two 12-month periods immediately after the exchange, the taxpayer’s personal use of the property must not exceed the greater of (i) 14 days; or (ii) ten percent of the number of days the property is rented at its fair market value.
Please remember, Rev. Proc. 2008-16 establishes a safe harbor for properties in a 1031 exchange to meet the ‘qualifying use’ guidelines. Failure to meet the safe harbor requirements will not necessarily disqualify a property for a Section 1031 exchange. It is advisable for property owners interested in a Section 1031 exchange to review their facts and circumstances with a tax advisor, if their ownership and use of a property will not meet the safe harbor guidelines.
Conversion of Use
Another opportunity with vacation or second homes is the ability to convert them from a ‘personal residence’ to a ‘business or investment property’, and vice versa. For example, a taxpayer may own and wish to sell a vacation or summer home with significant personal use. Because it is a second home rather than a principal residence, every dollar of gain on the sale may be subject to tax. With proper planning, the taxpayer can convert this personal residence to a ‘business or investment property’ prior to an exchange by abandoning its personal use, and renting it out for a period of time. It may then qualify for a Section 1031 exchange.
Remember, if you sell this property as your Relinquished property in a Section 1031 exchange, the Replacement property also must be rented out, and personal use must be limited, for a period of time for the exchange to qualify. After renting the property to another person at a fair market value rental, the taxpayer may convert the Replacement property from a rental property to a personal use vacation home or a principal residence. Pursuant to IRS regulations, the Replacement property of a Section 1031 exchange that is later converted to the taxpayer’s principal residence must be owned for five (5) years and occupied for two (2) years before it qualifies for the Section 121 principal residence exclusion.
Taxpayers interested in this strategy should carefully
consider the safe harbor guidelines of
Rev. Proc. 2008-16.
Summary
We invite you to contact Beacon Exchange Company if you are considering the sale or exchange of your second home. With proper planning and the ability to convert the use of properties from business to personal use, and vice versa, you may have the opportunity lessen or eliminate your capital gains tax liability through the use of either a Section 1031 exchange or the Section 121 Exclusion.
We look forward to hearing from you.
BEACON EXCHANGE COMPANY, LLC
241 A Street, Suite 310
Boston, Massachusetts 02210
Toll Free: 1-888-525-1031
Local Phone: 617-451-1031
Fax: 617-275-0909
Email: info@beacon1031.com
