Question: I am contemplating selling my vacation home which my family uses for personal purposes and also rents to third parties. If I purchase a new vacation home, can I defer the recognition of gain on the sale through a tax-deferred exchange?
Answer: The gain from vacation home sales can be deferred under the tax-deferred exchange rules in certain circumstances. The IRS has set forth a guideline as to whether or not a vacation home sale/reinvestment qualifies as a tax deferred exchange. To determine if you qualify, you must determine the number of days the home is rented to third parties and the number of days the home is used for personal purposes. If you satisfy these requirements, then the sale and reinvestment can qualify as a tax deferred exchange and you need not pay tax on any gain from the sale.
The Internal Revenue Code permits taxpayers to defer gain on the sale of real estate used for business or investment purposes if the proceeds are reinvested in other business or investment properties. Various rules must be satisfied to qualify for tax deferred exchange treatment including the requirements that all cash from the sale be reinvested in the replacement property, the replacement property be timely identified and, generally speaking, the acquisition of the new property occur within 180 days from the date of the sale of the relinquished property. Other rules apply as well. The failure to satisfy any of these requirements will prevent the gain on the sale from qualifying for tax deferred treatment and result in the selling taxpayer paying tax on any gain realized from the sale of the relinquished property.
The issue with a vacation home is whether the property qualifies as business or investment property. Clearly, a vacation home used strictly for personal purposes will not satisfy the business or investment use requirement. However, vacation homes which are used for personal purposes and rented to third parties can qualify under a safer harbor guideline established by an IRS Revenue Procedure. The safe harbor will apply if (a) the property is owned by the taxpayer for at least 24 months before the date of the sale, (b) during each of the two 12-month time periods immediately preceding the sale, the home is rented at fair market value for 14 days or more and (c) the taxpayer’s personal use of the home during this time period does not exceed the greater of 14 days or 10% of the number of days the home is rented at market rates.
On its face, the standard is somewhat stringent although some other rules may help vacation home sellers qualify for exchange treatment under the safe harbor requirements. Days where the property is vacant and available for rental are not treated as personal use days. Likewise, days where the property is being repaired or improved are not treated as rental days. Appropriate documentation should be retained keeping track of the number of days the taxpayer attempted to rent the property and the number of days the taxpayer was actually present on the property performing repairs or improvements.
Since you have not yet sold your vacation home, you can take steps to fall within the IRS safe harbor requirements. During the 24-month look back period, you can limit your personal use of the property and increase the rental use to satisfy the safe harbor. If the property is used by other family members during this time period, then you can charge rent at market rates rather than permitting them to live in the home at no or a discounted charge. Any combination of decreased personal use and increased rental of the property may help you accomplish your objectives.
As a final note, while it is recommended that you satisfy the IRS safe harbor in claiming exchange treatment with your vacation home sale, the safe harbor is not the only means of qualifying for a tax deferred exchange. Rather, the safe harbor is an IRS guideline which, if satisfied, will assure you the IRS will not challenge the exchange due to the property failing to qualify as business or investment real estate. If you otherwise come close but are unable to satisfy the safe harbor requirements, you may still want to claim exchange treatment although there is no certainty the IRS will not challenge your deferral of gain on the sale of the property.
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