Sabina and Jeremy live in Houston, Texas, and own a vacation home in Taos, New Mexico, where they have enjoyed vacations. When they bought the vacation home six years ago, they thought that they would rent it to other vacationers when they weren’t using it and allocate the rental money they received to pay the mortgage on the property.
After two seasons as landlords, Sabina and Jeremy decided that they didn’t need the extra headaches that seemed unavoidable in renting the house and dealing with tenant demands, complaints, and damage to their property. For the past four years, they have kept the property solely for their own use, except for occasional uses by close friends and relatives.
Now Sabina and Jeremy think that this would be a good time to cash in on the rise in property values in Taos over the last six years. When they bought the house, they paid $125,000. In today’s market, it’s worth $725,000. Jeremy knows someone who owns a dream house on the beach in Mexico and who would be willing to do a Section 1031 exchange for their vacation property in Taos.
Jeremy thinks that a Section 1031 exchange would be a great way to legally avoid paying capital gains taxes of about $90,000 that they would owe the government if they let go of the vacation home through a sale.
Is Jeremy overlooking anything important?
What should Jeremy and Sabina do?
Jeremy has indeed overlooked some very important limitations on the kinds of property that qualify for a Section 1031 exchange.
For property to qualify for a Section 1031 exchange, the property must be “held for productive use in a trade or business or for investment.” In the past, the IRS had ruled that this requirement excluded vacation homes from 1031 exchanges.
Recently, however, the IRS has declared that that property that is rented to others but also occasionally used by the owners for personal purposes (such as vacation homes) may be exchanged under Section 1031 when (1) the property has been owned by the taxpayer for at least 24 months immediately before the exchange, and (2) the period of the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10 percent of the number of days that the dwelling is rented at fair market value.
Sabina and Jeremy’s vacation home in Taos meets the first requirement — that is, they have owned it for at least 24 months — but does not meet the second requirement — because their personal use of the property exceeds the greater of 14 days or 10 percent of the number of days that it is rented at fair market value.
In order for Sabina and Jeremy to do a Section 1031 exchange with their Taos vacation property, they would first need to recharacterize the property for taxes purposes as property “held for productive use in a trade or business or for investment.”
They could do this by again renting it to vacationers. The date the IRS uses to determine whether property has been held for a qualifying business use is the date of the transaction; any previous use is theoretically irrelevant.
But while there is no clear rule regarding a “holding period” in order to recharacterize property as held for productive use in a trade or business or for investment, most tax advisors recommend a period of one to two years (in no case less than 12 months) in the new use, to be able to report rental income and deduct depreciation and other business expenses regarding the property on your tax returns for that period of time.
Or, under the new IRS ruling on 1031 exchanges and vacation homes, Sabina and Jeremy could discontinue their own use of the propery entirely — so that their personal use is less than the greater of 14 days or 10 percent of the number of days that the dwelling is rented at fair market value.
In addition, Jeremy has overlooked the geographic limitation on property that qualifies for a Section 1031 exchange.
While the IRS interprets the “like-kind” requirement under Section 1031 very broadly (all real property located in the United States is considered “like-kind” to all other real property located in the United States), the property must be located in the United States.
Foreign property (for example, the property in Mexico that Jeremy is interested in obtaining), or even in overseas U.S. possessions such as Guam and Puerto Rico, is not considered “like-kind” to any property located in the United States and is not qualified for exchange under Section 1031.
While Sabina and Jeremy can, under certain circumstances, do a 1031 exchange with their Taos vacation home, they can not trade it for una casa en la playa en México.
To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to firstname.lastname@example.org