It’s important to understand that there are three distinctively different types of real estate, some can be exchanged, some are prohibited from tax deferred exchange treatment. The three types are personal use, business/investment use and dealer property.
Favorable treatment exists for the sale of a personal residence if the property has been the primary residence of the taxpayer for two of the preceding five years. Section 121 of the Internal Revenue Code provides an exclusion from capital gains tax upon the sale of a primary residence of $250,000 per taxpayer or $500,000 for a married couple filing jointly. IRS Publication #544 provides complete guidance on a variety of scenarios and a few exceptions do exist for special circumstances.
Personal use property that has been used as a second/vacation home does NOT qualify for Section 121 exclusion. The surprising development is that upon sale of a second/vacation home, it will NOT qualify for Section 1031 tax deferral either. The Internal Revenue Service issued guidance in 2008 that puts to rest the confusion of when personal use property does, and does not qualify for exchange treatment.
Revenue Procedure 2008-16 establishes a safe harbor procedure for the sale of a vacation home that will qualify for Section 1031 treatment. Since you can only exchange property held for investment or use in a trade or business, personal use property, i.e.: vacation homes, is disallowed unless you can prove a change of use.
The revenue procedure clarifies that the dwelling unit (Relinquished Property) must be owned by the taxpayer for 24 months immediately preceding the exchange and the new unit (Replacement Property) must be held for 24 months immediately following the exchange. Personal use is limited to 14 calendar days or 10 percent of the days actually rented; whichever is greater, in the two twelve month periods before the exchange and for the following two twelve month periods after the new property has been acquired. The property must be rented to others for more than 14 calendar days in each of the 2 years preceding and the 2 years following the exchange to qualify for Section 1031 treatment.
It is advisable to keep detailed records of personal use and not to exceed the limits. In short, tighten up your record keeping and the tax reporting of your property. Be serious in your rental attempts; charge your friends the going rental rate when they use it. Keep detailed records of the dates you use it and what you did – especially for each maintenance day.
The second type of property is investment property or property used as business or trade property by the taxpayer. It is always exchangeable regardless of whether it is rented to others or used by the taxpayer in its own business. Section 1031 provides tax deferral if a Qualified Intermediary (QI) is engaged before the closing of the existing or Relinquished Property. At closing the net proceeds are sequestered away from the taxpayer and directed to the QI to function as escrow agent. Full tax deferral of capital gains tax is achieved when the exchangor has gone even or up in value, used all of the cash in the qualified escrow account and replaced the debt given up on the Relinquished Property with new debt on the acquired Replacement Property. The Replacement Property must be properly identified within 45 days of the sale of the Relinquished Property and acquired by the 180th day.
The third type or classification of real property is Dealer Property. This is the real estate owned by an individual or company that has property on its books as “held for sale” and is considered inventory in the hands of the owner. By definition, Dealer property is NOT exchangeable.
It is possible to convert property from one type to another without tax consequences. Your primary residence can become your rental/investment property and your investment/rental property can become your primary residence. How the property is used and accounted for the two years preceding and succeeding sale will determine the tax treatment. Make a plan before the sale to “never pay the tax.” Section 1031 is the conduit to wealth building, keep all your equity working for you!