Vacation Homes and Tax-Free Dispositions

By Andrew Smith June 4, 2012

According to the latest Census Bureau data, Maine truly does live up to its moniker – Vacationland.  16.4% of all housing units in the State of Maine are held for seasonal, recreational, or occasional use, representing the highest percentage in the United States (Vermont and New Hampshire ranked 2nd and 3rd at 15.6% and 10.4% respectively).  This serves as a great reminder of a potential tax deferral strategy available to taxpayers who own trade or business property and/or vacation homes.

Several years ago I consulted with a retiring business owner.  He was selling his business and his home and planning to retire to Florida.  As is the case with many business owners, the operating business and real estate were held in separate entities and he was interested in reducing the tax burden associated with the sale.  I suggested a like-kind exchange for the real estate whereby he would replace the commercial property with residential rental units.  This plan appealed to the taxpayer and over the next several months he was able to defer all gain resulting from disposition of his commercial real estate.  He did so by using the sales proceeds from his commercial real estate to acquire a property in Florida and a lake house in Maine in a properly executed “like-kind exchange.”

Like-kind exchanges are governed by Code Section 1031 and assuming certain requirements are met, it allows taxpayers to exchange trade or business property or investment property for similar property.  The similar property definition is quite broad when it comes to real estate.  All real estate is considered similar in nature so it really comes down to whether or not the property meets the business use or investment purpose definition.

Revenue Procedure 2008-16 provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under Code Section 1031 even if it is occasionally used for personal purposes.  The safe harbor rules for both the relinquished property and the replacement property are essentially identical.  The taxpayer must own or have owned the property for at least 24 months either before or after the exchange.  The 24 month ownership period is further broken down into two 12 month periods.  During each of those 12 month ownership periods, the unit must be rented at fair market value for at least 14 days and the taxpayer’s personal use of the dwelling cannot exceed the greater of 14 days or 10 percent of the number of days rented.  Note that these are fiscal years based on the date of the exchange, as distinguished from calendar years beginning on January 1.

Section 1031 relates to business property; it does not apply to a taxpayer’s personal residence.  However, Code Section 121 allows for certain gain on the sale of a personal residence to be excluded from income.  Because the taxpayer’s home was the principal residence for the taxpayer and his wife for at least two out of the last five years (one of Section 121’s criteria), he was able to defer up to $500,000 of the gain associated with its sale.  Also, because the value of the two replacement properties exceeded the value of the commercial property he sold (one of Section 1031’s criteria), 100% of the gain associated with the sale of the commercial property was deferred.  The combination of these two provisions allowed the taxpayer to sell multiple properties at a gain and legitimately avoid or defer paying tax on either transaction.  The taxpayer in this example will rent out both the Florida property and the Maine lake house, being careful to limit his personal use of each property to less than 14 days for the 1st 24 months following acquisition.  After 24 months, the safe harbor will be satisfied and the use requirements will be removed.  The taxpayer then can cease renting one or both of the dwelling units.  In fact, if he was so inclined, the taxpayer could then move into the Florida property and declare that his personal residence.  If the taxpayer and his wife live in that dwelling for at least two additional years, they could then sell that property and exclude up to $500,000 of any gain from that transaction as well.

As evidenced by this example, Section 1031’s like-kind exchange provisions can provide some excellent tax deferral opportunities related to business property.  Section 121’s provisions can allow complete exclusion of certain gains related to a principal residence.  When these provisions are used together and combined with proper planning, a taxpayer eventually may exclude gain resulting from sales of both types of property.  There are numerous requirements involved with properly executing such exchanges, only a few of which are addressed by this article.  Although perhaps not difficult to meet, the transaction may be fully taxable if the criteria are not met.  To gain an understanding of the rules or for advice structuring a transaction to qualify for these benefits, please contact Andy Smith or your BNN advisor at 1.800.244.7444.