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08/21/2007

Rules Differ For Tax-Free Exchanges On Vacation Homes

The Federation of Exchange Accommodators is a national trade organization formed in 1989 to represent those who are directly involved in Section 1031 Exchanges. At the organization�s midyear conference attendees shared common challenges they faced regarding their property...vacation homes topped the list.

Section 1031 of the IRS code allows a property held for business or investment to be exchanged tax free for another �like kind� property of equal or greater value if the exchange adheres to specific guidelines. Which category one�s property falls under is usually determined by how many personal days you use the property for vacation.

If your vacation home is an investment property, the rule is that personal days must not exceed 14 a year, or 10% of rental days, whichever is greater. If you want to use the vacation home in a tax-deferred exchange, it must be used as a rental at least for the entire previous year and rented out at fair market value. Homeowners can flip-flop the status of the vacation home each year.

When planning a 1031 exchange, make sure the home held investment status for at least the previous year before attempting an exchange. Although there are no absolute rules as to how long the property should be held as an investment, accountants suggest that the property show up as a rental on at least two consecutive tax returns.

The consecutive part is vital. If the property reverts back to a second home in the year before the exchange, it would not be eligible for a 1031 trade.

A popular tax strategy is to convert the second home to a primary residence. Say a couple retire and sell their longtime family home, pocketing $500,000 tax free from its sale. The couple move to their vacation home, making it their primary residence. Two years later, they can sell the place, move to an apartment and pocket up to $500,000 tax free again because it had become their primary residence.

Although vacation homes can certainly help with your financial picture, make sure you are clear on the status before you attempt to trade or sell.


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