QI have owned and rented a house down south since 1989 and plan to sell it as part of a section 1031 Starker exchange. I am seriously considering buying a beach house in Virginia, which I intend to rent during the summer months, as well as using it for 14 days or fewer during the year.
Am I permitted under the 1031 tax laws to exchange a rental unit for a vacation home?
AThe answer depends on how you use that vacation home.
Let's first review the rules for a Starker exchange, which is a way to defer paying capital gains tax on the sale of an investment property. These exchanges are also known as like-kind exchanges or Section 1031 exchanges, after the portion of the tax code that covers them.
These exchanges have their own vocabulary. The property you sell is called the "relinquished property." The new property is called the "replacement property."
Let's look at an example: You bought a house back in the 1980s for $100,000, and it is now worth $600,000. Forgetting for this discussion expenses or improvements (all of which come into play when determining profit), you have made a gain of $500,000. Should you simply sell the house, the IRS would require you to pay capital gains tax. At the current 15 percent rate, that would amount to $75,000. The state where you live may also tax this profit.
So you decide that you want to engage in a 1031 exchange. You sell the relinquished property. The net sales proceeds are then held by a third party, called an "intermediary."
Within 45 days from the day the relinquished property is sold, you must identify the replacement property and advise the intermediary of your decision. You can identify up to three replacement properties. (If more than three such properties are identified, the collective value of these properties cannot exceed 200 percent of the value of the relinquished property unless at least 95 percent in value of the identified properties are actually purchased.)
The replacement property you buy must be equal or greater in price than the selling price of the relinquished property. Otherwise you will have to pay tax on the difference between the two properties.
In our example, you obtain the replacement property for $600,000. All of the cash from the relinquished property must go directly into that new property. You are not able to control or use the sales proceeds for any purpose other than to buy the replacement property.
Keep in mind that a Starker exchange is not a "tax-free" arrangement, it is a tax-deferred process. Why? Because although you have paid $600,000 for the new property, the tax basis of the relinquished property becomes the basis of the replacement property. Thus, when you ultimately sell the replacement property, and do not engage in another Starker exchange, you will have to pay all of the capital gains tax that you had previously deferred.
What kind of property is eligible for a 1031 exchange? The law requires that the property be "like-kind." In other words, you must exchange real estate for real estate. You can exchange a single-family house for a farm, an office building, a condominium or cooperative unit, or even a vacant lot. The bottom line is that you must exchange one piece of investment property for another investment property.
Does a vacation home meet the "like-kind" test? Here, we have to look to another section of the IRS Code, namely section 280A. Under the law, if an individual (or a subchapter S corporation) uses any property for more than 14 days per year -- or 10 percent of the number of days the property is rented, whichever is more -- then it is a home, not an investment property.
According to the IRS: "You must first consider if you use your dwelling as a home. You are considered to use a dwelling as a home if you use it for personal purposes during the tax year for more than the greater of 14 days or 10 percent of the total days it is rented to others at a fair rental price. It is possible that you will use more than one dwelling unit as a home during the year. For example, if you live in your main home for 11 months and in your vacation home for 30 days, your home is a dwelling unit and your vacation home is also a dwelling unit, unless you rent your vacation home to others at a fair rental value for more than 300 days during the year."
Thus, because you plan to use the beach house for fewer than 14 days a year, the IRS does not treat this as a home and it is possible that the beach house would qualify as like-kind exchange property. I use the word "possible" because there do not appear to be any court cases or IRS rulings on this issue.
To be on the safe side, you might want to consider avoiding any personal use of the beach house for at least two years. The IRS might take the position that any personal use defeats the requirement under the 1031 requirements that the replacement property be for investment purposes.
For additional information, go to the IRS Web site (www.irs.gov) and refer to Tax Topic 415, Renting Residential and Vacation Property.
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, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.