QI have rented out a house in Texas for more than 10 years and would like to sell it as part of a 1031 Starker tax-free exchange. I plan to sell the Texas house and buy a rental unit near Virginia Beach. I have never occupied or used the Texas property and have exclusively rented it to tenants over the years. I intend to rent the replacement property beach house during the summer months and also use it for 14 days or less during the rest of the year.
Am I permitted under the 1031 exchange laws to swap a rental unit for a vacation home? In other words, is this considered a "like-kind" exchange?
AThe answer depends on the use you plan for the vacation home.
But first, I want to correct a misstatement in your question. Section 1031 of the Internal Revenue Code is the section that permits what's known as a "Starker exchange." You referred to it as a "tax free" exchange. It is not.
A Starker exchange is best described as a "tax-deferred" transaction. If you sell your Texas house -- called the "relinquished property" in an exchange -- the profit you make would be taxed at the Federal capital gains tax rate, currently 15 percent. You would also have to pay the applicable state or local tax. However, if you arrange to "exchange" the Texas property, and comply with all the legal requirements for a 1031 exchange, the tax that you would have paid is deferred.
Say you purchased the Texas property for $50,000 and you will sell it for $350,000. (For purposes of this example, we will ignore depreciation and any improvements you have made.) Your profit would be $300,000. If you do not use a 1031 exchange, you will owe the IRS $45,000 in capital gains tax.
However, if you exchange the property, and buy a replacement property for $400,000, you will not have to pay the tax at this time. But the law does not give you a complete break. Even though you will pay $400,000 for the new property, the tax basis of the relinquished property becomes the basis of the replacement property -- $50,000. Basis is defined as the original cost of the property, plus any improvements you make during the period of ownership.
Thus, if you sell the replacement property later, unless you engage in another 1031 exchange, you will ultimately have to pay the capital gains tax on all the profit over the years. In our example, if you sell the replacement property for $550,000, your profit is $500,000 ($550,000 minus $50,000), even though you paid $400,000 for that real estate.
Now back to your question. There is no statutory definition of "like-kind." However, the IRS and the Tax Court have made it clear that the replacement property has to be real estate. This means that you can swap your Texas single-family house for another such property, or any other kind of real estate. A house can be exchanged for an office building; a condominium unit can be exchanged for a vacant lot; a shopping mall can be exchanged for a farm. As long as the replacement property is real estate, it will pass muster with the IRS.
But it is possible that a vacation home could create problems. To have a successful 1031 exchange, the law requires that both the relinquished and the replacement property be "held for productive use in a trade or business or for investment."
Another section of the tax code (Section 280A) creates special rules dealing with vacation properties. If the vacation home is not used by the taxpayer for personal purposes for the greater of more than 14 days during the tax year or more than 10 percent of the number of days during the year in which the property is rented out, it is considered investment property. Accordingly, you may be able to acquire the Virginia Beach property as the replacement property in your 1031 exchange, as long as you stick with your plan to use it for 14 days or less.
However, it is my understanding that there are no reported court cases dealing with this issue. Thus, it is possible that some IRS auditor might find that your personal use of the property, in compliance with Section 280A, defeats the investment purpose and would not honor the exchange.
Your best bet: For at least two years, do not use the Virginia property at all, so that there is no doubt that it is a rental property.
Keep in mind that when you sell the relinquished property, you must identify the replacement property within 45 days from the date of its sale, and you must take title to that property at the earlier of 180 days from the sale date, or when your income tax return for the year in which the property is sold is due. These deadlines are spelled out in the law and cannot be waived.
A 1031 exchange is a valuable tool for real estate investors, but must be done properly. Consult your tax and legal advisers before you make any commitments or sign any contracts.
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.