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Let’s say you have a highly valued vacation home that you’re willing to sell for any reason. If you just sell it, you could end up with a huge income tax bill. See my previous column for this sad outcome. Ugh.

But if you’re still bullish on real estate and don’t like to pay taxes unnecessarily, you can instead trade your vacation home for another vacation home or just about any other type of property in a tax-deferred exchange under Section 1031 of our favorite law. Tax code. Believe it or not, the IRS has provided a recipe for how to trade real estate for vacation tax-free, but it may take you a while to get it to work.

I will tell you how to do it. But first, some necessary background information.

What is a section 1031 exchange? Here are the basics

A section 1031 tax-deferred exchange, if available, is a great tool for property owners. This allows you to dispose of one property (abandoned property) and acquire another (replacement property) without initiating a current income tax account due to the appreciation of the abandoned property (the difference between its fair market value and its tax base).

Tax-free income is transferred to the replacement property, where it remains tax-free until you sell the replacement property in a taxable transaction. But if you still own the property when you die, any taxable income can be completely washed away under current federal income tax rules thanks to another favorable provision that increases the tax base of the deceased’s estate until the date of his death. value. Under this deal, taxable income can be deferred indefinitely or even eliminated entirely if you leave this brutal realm while still owning property.

Naturally, there are difficulties in organizing a successful Section 1031 exchange. I have summarized them in this recent column.

It’s important to know that you can earn taxable income even on a successful Section 1031 exchange, to the extent that you receive cash in the trade. The same is true if you take on a mortgage on a new property that is smaller than the mortgage on a dispossessed property that the new owner is taking on. Worse still, the IRS will treat an exchange that does not comply with all of the rules of Section 1031 as a taxable sale of the forfeited property with a subsequent tax deduction. Ouch! For these reasons, I recommend hiring a tax professional who has experience with 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 Drill Rig 1031 for Vacation Homes

In the 2008-16 tax procedure, the IRS opened a “safe harbor” that allows you to use the section 1031 tax-deferred exchange regime for the exchange of vacation properties, including “mixed” vacation homes that you rented out part of the time. and used personally part of the time.

To be eligible for safe harbor, you must meet the guidelines below for both abandoned property (vacation property that you give up in an exchange) and replacement property (property that you receive in an exchange). When you comply with these guidelines (along with all other Section 1031 exchange rules), your swap will qualify for safe harbor, which means it will automatically pass IRS verification.

Recommendations for alienated property

To opt out of a vacation property, you must pass both of the following tests.

1. You must have owned it for at least 24 months immediately before the exchange.

2. During each of the two 12-month periods during the 24 months immediately preceding 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 was rented at market rates.

Property Replacement Recommendations

To replace a property, which can be almost any type of real estate, the following tests must be passed.

1. You must continue to own it for at least 24 months after the exchange, and you must own it for rental or commercial purposes.

2. If the replacement property is another vacation home, you must pass a more difficult test. During each of the two 12-month periods within the 24 months immediately after 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 days property is rented at market rates.

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

Let’s say you have a nice mixed-use vacation home that’s worth $1 million in today’s overheated market. Your property tax base is only $200,000. There are no mortgages.

If you were to sell this place, you would have to report a taxable profit of $800,000 ($1 million – $200,000). Not good. But let’s say you want to buy a property that you will rent or hold for investment, or another vacation home that will pass real estate replacement tests. Good. You can negotiate an exchange under section 1031 and avoid any current tax deductions.

Let’s say you found another $1.1 million property you’d like to own. You can trade your vacation home for a new replacement property and deposit $100,000 in cash to even the deal. If you comply with the aforementioned safe harbor rules for both properties, you may be able to make an exchange under section 1031 and thus avoid any current income tax. Congratulations. Your tax base on the replacement property is $300,000 ($1.1 million minus $800,000 of gains carried forward to the dispossessed property).

bottom line

The ability to arrange for an IRS-approved Section 1031 exchange of an appraised vacation home is a great opportunity to save on taxes, especially if the appraisal is huge, as in the previous example.

While you cannot trade a Section 1031 vacation home that you have used solely for personal use, all is not lost. You can still set yourself up for future Section 1031 exchange by leasing the property for a number of days over the next 24 months to comply with the rules for the safe keeping of abandoned property. You can then find a suitable replacement property and negotiate a section 1031 deal.

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