Dear Tax Payer,
An improved economy, strengthened real estate market in many areas, and a favorable interest rate environment has led to a resurgence of interest in vacation or second homes. These properties offer a chance to provide the family with a place to rest and relax at a reduced cost when compared to expensive short-term resort rentals, and at the same time give owners a shot at capital appreciation over the long term. They also offer a chance to earn some rental income when the owner or family members aren’t using the property. This second installment of a two-part article (see article below) about current tax rules that apply when taxpayers dispose of (by selling or exchanging) vacation homes along with some suggested planning moves.
Dean Holland, CPA
Making the Best Tax Use of a Vacation Home Under Current Rules- PART 2
An improved economy, strengthened real estate market in many areas, and a favorable interest rate environment has led to a resurgence of interest in vacation or second homes. These properties offer a chance to provide the family with a place to rest and relax at a reduced cost when compared to expensive short-term resort rentals, and at the same time give owners a shot at capital appreciation over the long term. They also offer a chance to earn some rental income when the owner or family members aren’t using the property. This second installment of a two-part article about current tax rules that apply when taxpayers dispose of (by selling or exchanging) vacation homes along with some suggested planning moves. The first installment covered the rules that apply to vacation homes that are rented to others during the year.
Tax-Free Sale of Vacation Home
A taxpayer may sell his regular home at retirement and move into what had been his vacation home. If the vacation home is later sold, gain on the sale of both homes is eligible for the up-to-$250,000 exclusion ($500,000 for qualifying married taxpayers) if each is owned and used as a principal residence for at least two of the five years preceding the sale date of each home, and two years elapse between the sales. Note that under IRS rules, a reduced maximum exclusion may apply to taxpayers who (1) fail to qualify for the 2-out-of-5-year ownership and use rule, or (2) previously sold another home within the 2-year period ending on the sale date of the current home in a transaction to which the exclusion applied. That reduced maximum exclusion rule applies if the taxpayer’s failure to meet either rule occurs because he must sell the home due to a change of place of employment, health, or to the extent provided by regulations, other unforeseen circumstances.
Reduced homesale exclusion for nonqualified use. The above rule excluding home sale gain if the two-out-of-five-year rule is met won’t apply to the extent gain from the sale or exchange of a principal residence is allocated to periods of nonqualified use. Generally, nonqualified use is any period (other than the portion of any period before Jan. 1, 2009) during which the property is not used as the principal residence of the taxpayer or spouse. For example, use of a residence as a vacation home or as rental property is nonqualified use.
HATS observation: It’s important to note that the exclusion isn’t reduced for nonqualified use; rather, it’s the gain potentially eligible for the exclusion. Thus, if the home sale gain is large enough, the seller may be able to use the full home sale exclusion despite extensive periods of nonqualified use.
HATS illustration: A single taxpayer buys a residence this year, uses it as a vacation home for four years, and then uses it as a principal residence for four years. He owns no other residences. If he subsequently sells the home and realizes a gain of $500,000, half of the gain will be allocable to non-qualifying use and subject to tax as long-term capital gain (and the 3.9% surtax on unearned income), but the other half will qualify for the full $250,000 home sale exclusion.
The amount of gain allocated to periods of nonqualified use is the total amount of gain multiplied by a fraction (1) the numerator of which is the aggregate periods of nonqualified use during the period the property was owned by the taxpayer, and (2) the denominator of which is the period the taxpayer owned the property.
Tax-Deferred Exchange of Vacation Home – 1031 Exchange
Under IRS Code Section 1031, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment. Property held for productive use in a trade or business may be swapped for property held for investment, and property held for investment may be swapped for property held for productive use in a trade or business.
It’s well settled that personal residences can’t be exchanged tax-free under Code Section 1031 because they aren’t held for productive use in a trade or business or for investment. However, under a prior revenue ruling, a safe harbor exists under which a dwelling unit (real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities) will qualify as property held for productive use in a trade or business or for investment for IRS Code Section 1031 purposes even though it is occasionally used for personal purposes.
Under the revenue ruling, the IRS won’t challenge on personal use grounds whether a dwelling unit is relinquished or replacement property under the exchange rule requiring such property to be held for productive use in a trade or business or for investment if:
- . . . the taxpayer owns the property for the qualifying use period (for relinquished property, at least 24 months immediately before the exchange; for replacement property, at least 24 months immediately after the exchange); and
- . . . within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange (in the case of relinquished property) or immediately after the exchange (in the case of replacement property), (i) the taxpayer rents the dwelling unit to another person(s) at a fair rental for 14 days or more, and (ii) the period of the taxpayer’s personal use of the dwelling unit doesn’t exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
For relinquished property, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months before that day), and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months before that day). For replacement property, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.
HATS illustration: Tina owns a beach condominium (relinquished property) that she intends to exchange in a tax-free like-kind exchange for a lake house (replacement property). Tina has owned the condominium for five years before the exchange. During each of the two 12-month periods immediately preceding the exchange, she used the condominium for personal purposes for 16 days and rents it at fair rental for 163 other days. She meets the 14-or-more rental day’s requirement. The number of days on which she used the condominium for personal purposes (i.e., 16) doesn’t exceed 16.3 (10% of 163, the number of other days on which the home is rented at a fair rental). Thus, Tina’s personal use of the condominium also meets the use test for purposes of the safe harbor.
If she also satisfies the safe harbor’s ownership and usage periods for the lake house (replacement property), the swap transaction will be treated as a like-kind exchange (assuming all the other conditions are satisified) even if Tina subsequently uses that property strictly as a personal residence.
Personal use occurs on any day on which a taxpayer is treated as having used the dwelling unit for personal purposes.
HATS observation: a taxpayer is treated as using a dwelling unit for personal purposes for a day if the unit is used for personal purposes by: (1) the taxpayer or any other person who has an interest in the dwelling unit or by a member of the family of the taxpayer or the other person; (2) any individual who uses the unit under a reciprocal use arrangement (other than use by a person having an equity interest in the property under a shared equity financing agreement); or (3) by any individual unless for that day the dwelling unit is rented for a fair rental. A taxpayer is not treated as using a dwelling unit for personal reasons if the unit is rented out or held for rental at a fair rental to any person for use as a personal residence. Personal use days don’t include days the taxpayer used a dwelling unit as his principal residence: (1) before or after a rental (or attempted rental) period of 12 or more consecutive months beginning or ending in the tax year; or (2) before a consecutive rental (or attempted rental) period of less than 12 months beginning in the tax year, at the end of which the residence is sold or exchanged.
The safe harbor applies only to the determination of whether a dwelling unit is held for productive use in a trade or business or for investment. Thus, a taxpayer using the safe harbor also must satisfy all other requirements for a like-kind exchange and the like-kind exchange regulations.
HATS observation: The replacement property received in the exchange ultimately may qualify for the home sale exclusion if the requirements are met. However, taxpayers who received a vacation home as replacement property in a like-kind exchange should be aware that any rental use of the replacement property would be considered to be a period of nonqualified use on a later sale or exchange of the residence denying the home-sale exclusion for periods of nonqualified use.
Taxpayers also should be aware that if they acquire a home in an exchange in which any gain wasn’t recognized, the Code Section 121 exclusion does not apply to the sale of the home by the taxpayer (or by any person whose basis in the property is determined, in whole or in part, by reference to the basis in the hands of the taxpayer) for the 5-year period beginning with the date of acquisition.
In conclusion, the rules regarding vacation home and the tax-free exchange provisions of Code Section 1031 are quite complex. As such, I always recommend to our firm’s real estate clients that an experienced intermediary be used to ensure that the exchange requirements are properly met.