Published: September 19, 2008
Author: Steven Brezinski
New Safe Harbor for Tax Deferred Exchanges of Second Homes
In a tax deferred exchange, gain is not recognized if a replacement property of equivalent value is acquired within specified time limits. In order for property to qualify for a tax deferred exchange, it must be held for investment or used in a trade or business. Property used exclusively or primarily for personal purposes does not qualify.
The IRS recently issued a revenue procedure, Rev. Proc. 2008-16, which provides a safe harbor for tax deferred exchanges involving residential property that is used in part for personal purposes. If the safe harbor tests are met, the IRS will not challenge the qualification of the property as a trade or business or investment property under Section 1031.
Under the revenue procedure, both the old relinquished property and the new replacement property are tested for personal use in the two 12 month periods ending on the date of the sale of the old property and starting on the date of the acquisition of the new property. The 12 month periods are not calendar years.
Two tests must be met: first, each property must be rented at fair market value for at least 14 days in each of the two 12 month periods. Second, the personal use of each property cannot be more than the greater of 14 days or ten percent of the number of days the property was rented at fair market value.
If the safe harbor is met, personal use of the old property prior to the beginning of the 24 month period and of the new property after the end of the 24 month period will not be taken into account. With proper planning, it will be possible to convert a vacation home into a rental property and sell it in a tax deferred exchange or acquire a vacation home as a replacement property in a tax deferred exchange and convert it to personal use without fear of losing the tax deferred exchange.
Reduction on Home Sale Exclusion for Second Homes Converted to Principal Residences
Under Section 121 of the Internal Revenue Code, gain from the sale of a principal residence is excluded up to $250,000 for a single taxpayer and $500,000 on a joint return. You can only have one principal residence and you must use the property as a principal residence for at least two out of the last five years prior to the sale. Prior to the change in the law, a second home converted to a principal residence and sold after two years of use would enjoy the gain exclusion.
As part of the Housing and Economic Recovery Act of 2008 signed into law on July 30, 2008, a portion of the gain on a sale of a principal residence will now be taxed if the property was used for other purposes prior to its first use as a principal residence. The new rule is effective for periods beginning 2009, so use prior to 2009 will be disregarded.
Suppose that John and Mary buy a second home on January 1, 2009 for $200,000. They retire on January 1, 2011 and use it as their principal residence. They sell the property on January 1, 2014 for $500,000. Two fifths of the $300,000 gain, or $120,000, will be taxed and three-fifths will be excluded as gain from the sale of a principal residence.
Periods of nonqualified use after the property is first used as a principal residence do not affect the gain exclusion, but the owner still must meet the principal residence test at the time of sale (two out of the last five years as a principal residence).
Steven A. Brezinski is an attorney with Axley Brynelson, LLP, practicing in the areas of tax planning and tax litigation, estate planning and probate, land use law and regulation, non-profit organizations, and general business and real estate law. He can be reached at 608.283.6723 or email@example.com.
Axley Brynelson is pleased to provide articles, legal alerts, podcasts and videos for informational purposes, but we are not giving legal advice or creating an attorney/client relationship by providing this information. The law constantly changes, and our publications may not be currently updated. Before relying on any legal information of a general nature, please consult legal counsel as to your particular situation. While our attorneys welcome your comments and questions, keep in mind that any information you provide us, unless you are now a client, will not be confidential.