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Savvy Investors Can Now Avoid Paying Tax When Exchanging Vacation Property

Good news from the IRS. The IRS recently adopted a “loophole” that permits savvy investors to exchange one vacation property for another, and avoid paying any tax on the gain.

Section 1031 of the Internal Revenue Code permits a taxpayer to exchange one property held for productive use in a trade or business or for an investment (relinquished property) for another property of like kind, also held for productive use in a trade or business or for investment (replacement property).

A taxpayer does not have to recognize gain or loss on the exchange, as long as it is structured properly.

For years, the IRS has maintained that a “personal residence” is not property “held for productive use in a trade or business or for investment.” Therefore, it could not qualify for Section 1031 tax deferred exchange treatment. The taxpayer would have to pay tax on any gain, even if they used the proceeds to buy another vacation, or investment property. Until now.

The IRS recently enacted Revenue Procedure 2008-16. This provides taxpayers with a safe harbor under which a second home or vacation property will qualify as a Section 1031 investment property, even though the taxpayer occasionally uses the property for personal purposes.

How is this possible? The IRS established use standards for both the “relinquished property” and the “replacement property”. The property must be owned by the taxpayer for at least 24 months immediately before the exchange, for “relinquished property”, and for at least 24 months immediately after the exchange, for “replacement property”. Also, in each of the two 12 month periods immediately before and after the exchange (a) the taxpayer must rent the property to another person at “fair rental” for at least 14 days and (b) the taxpayer’s personal use of the property can not exceed the greater of 14 days or 10% of the number of days during the prior year that the property is rented. In other words, the taxpayer can use the property for personal use but, the amount of personal use is limited and, the property must be rented out for a minimum period of time. The definition of what constitutes “personal use” is pretty broad, and includes use by the taxpayer and their family members. Fair rental is determined based upon all the facts and circumstances that exist when the rental agreement is entered into. A taxpayer utilizing this new safe harbor must satisfy all other requirements for a Section 1031 like kind exchange.

A word of caution: property “held primarily for sale” to customers may not qualify as investment property under Section 1031. For example, a builder may be deemed a “dealer” engaged in the sale of real estate to customers in the ordinary course of its business. Whether or not Section 1031 tax deferred treatment is available, depends on the facts of each case.

In sum, that appreciated vacation home can now be “exchanged” for a more expensive property, without paying tax on the gain, if the taxpayer can dock at the IRS Revenue Procedure 2008-16 safe harbor.

For further information, contact Gregg A. Nathanson, Esq., an attorney at the law firm of Couzens, Lansky in Farmington Hills, Michigan, at 248-489-8600 or gregg.nathanson@couzens.com

The information contained herein does not attempt to give specific legal advice. For advice in particular situations, the services of a competent real estate attorney (preferably Gregg Nathanson) should be obtained. These materials are the exclusive property of Gregg A. Nathanson, Esq., and no reprint or other use of the information contained herein is permitted without Mr. Nathanson's express prior written authorization.