1031 Exchange

Many investors are taking advantage of the like-kind exchange, which is authorized under Section 1031 of the Internal Revenue Code. These exchanges are commonly referred to as “Starker” exchanges.

But if you own a vacation home, there has been a lot of confusion as to whether that property qualifies for the exchange.

Effective March 10, 2008, we now have what is known as a “safe harbor” for these vacation-home exchanges.

In order to have a valid Starker exchange, only investment properties can be swapped with other investment properties. There are other tax benefits for homes used as the principal residence, such as the ability to shelter up to $500,000 of the profit you have made (if you are single or file a separate tax return, this exclusion is limited to $250,000 of gain.)

According to Revenue Procedure 2008-16, the property must be a house, apartment, condominium or similar improvement that “provides basic living accommodations including sleeping space, bathroom and cooking facilities.” This can include mobile homes and boats.

A safe harbor simply means that if you follow the guidelines promulgated by the IRS, your tax return will not be challenged.

To qualify the relinquished vacation or second home for the exchange, it must have been owned by the taxpayer for at least 24 months immediately before the exchange. (The IRS refers to this as the “qualifying use period.”)

And in addition, for each of the two years within the qualifying use period, the taxpayer must have rented the property at a fair rental for at least 14 days. Furthermore, the taxpayer cannot have used it 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 rental.

Sounds confusing, but it is the law. The IRS does not want taxpayers to claim that their property is “investment” when in fact they take their families 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 that use exceeds the use restrictions described above, you will not be able to do a Starker exchange. Confirm this with your own accountant.

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 you follow the rules, a 1031 exchange is a very valuable tool. For example, if you purchased your investment property for $200,000 and sold it for $400,000, you would in most cases have to pay the IRS $30,000, in addition to any state or local tax. However, if this property were sold in connection with a Starker exchange, and you obtained another investment property worth at least $400,000, you would not have to pay any capital gains tax. Instead, the basis of the old property would be transferred to the new one; you would have to pay the tax only when you ultimately sold the replacement property and did not engage in yet another 1031 exchange.

But you must understand that a 1031 is not a “tax free” process; it simply defers the time when you have to pay the capital gains tax.

And even if you follow the vacation rules outlined in the recent Revenue Procedure, you still have to comply with the general requirements of a like-kind exchange. You should consult your tax and legal advisors about your specific situation.

The rules are complex, and must be followed religiously. 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. Please query your tax advisor and attorney before you get started!