Safe Harbor for Vacation-Home Exchanges, If You Follow the Letter of the Law
As promised, the IRS last month updated its guidance on the use of Starker exchanges for vacation homes.
Such transactions, also known as like-kind exchanges or Section 1031 exchanges, allow owners of investment property to defer capital gains tax. The Treasury inspector general for tax administration last fall ordered the Internal Revenue Service to increase audits and enforcement of these exchanges.
In particular, the inspector was concerned about vacation homes and instructed the IRS to "provide clear guidance to taxpayers regarding the rules and regulations governing like-kind exchanges with respect to second and vacation homes that were not used exclusively by owners."
The inspector general expressed concern that "the absence of clarification on this issue leaves unrebutted the sales pitch of like-kind exchange promoters who may encourage taxpayers to improperly claim deferral of capital gains tax by selling non-qualified second and vacation homes through 'tax-free' exchanges."
The IRS agreed, and we now have a "safe harbor" for these exchanges, which means that if you follow the IRS guidelines, your tax return will not be challenged.
First, let's review the basics about Starker exchanges.
Usually, when an investment property is sold, the seller must pay tax on the profit. If the property was owned for more than a year, the profit normally is considered a long-term capital gain. (The capital gains tax rate varies according to income; the highest rate is 15 percent.)
For example, if you bought your investment property for $200,000 and sold it for $400,000, in most cases you would have to pay the IRS $30,000 in addition to any state or local tax.
However, if the taxpayer engages in a Starker exchange and strictly follows the rules, the tax liability can be postponed. In such a transaction, the investor effectively sells one property (called the "relinquished property") and buys another of equal or greater value (the "replacement property") but uses a mechanism that, for tax purposes, treats it more like a switch.
The tax basis of the old property -- the amount you paid for it, adjusted for various expenses -- becomes that of the new one. The tax is postponed until you sell the replacement property.
For the relinquished vacation or second home to qualify for the exchange, it must have been owned by the taxpayer for at least 24 months immediately before the exchange. The IRS refers this as the "qualifying use period."
In addition, for each of the two years in the qualifying-use period, the taxpayer must have rented the property at a fair rental rate for at least 14 days.
Furthermore, the taxpayer cannot have used the property personally for the greater of 14 days or 10 percent of the number of days during each 12-month period that the property is rented at a fair rate. The IRS does not want a taxpayer to claim that his property is an investment when in fact he uses it to take his family to the beach for the entire summer.
You can, of course, periodically go to your second home to inspect it and make any necessary repairs. However, if those visits exceed the use restrictions described above, you will not be able to do a Starker exchange.
What is fair rental? Here, the IRS falls back on its standard formula: It will look to the facts and circumstances of each case. To be on the safe side, have at least two real estate agents provide you with a written market analysis of the rents being charged for similar properties in the area or areas where the relinquished and the replacement properties are located.
What about the replacement property? Here, the same rules apply. If you swap one property for another, you must rent it out for at least two years or the exchange will fail.
If that happens, the taxpayer will have to amend the tax return "and not report the transaction as an exchange."
That could be calamitous. Remember, you have to use all of the proceeds from the sale of the relinquished property to obtain the replacement property. If you later fail to comply with the requirements and have to file an amended return, you'll have to pay the tax on the capital gain. Where will you get the money to do this?
Besides the updated vacation-home rules outlined in the recent Revenue Procedure, taxpayers still have to comply with the general requirements of a like-kind exchange. Here is a brief synopsis:
· You must identify the replacement property within 45 days after you have gone to settlement on the relinquished property. The identification must be as specific as possible. You can identify up to three replacement properties. However, if you want to identify more, the aggregate fair market value of the properties cannot exceed 200 percent of the value of the relinquished property or properties.
· The price of the replacement property must be at least equal to the sales price of the relinquished property. All of the sales proceeds from the relinquished property must be held in escrow by a qualified intermediary; under no circumstances can you have any access to that money. It must all go into the purchase of the replacement property.
· You must acquire the new property within 180 days from the day you disposed of the relinquished property.
These rules are complex, and they must be followed meticulously. A successful 1031 exchange is a valuable tool for investors, but any misstep will cause you to have to pay the capital gains tax you are trying to defer.
Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, http:/