Small Business Taxes & Management

Special Report


Like-Kind Exchange of Vacation Properties

 

Small Business Taxes & ManagementTM--Copyright 2016, A/N Group, Inc.

 

Like-Kind Exchange Basics

You may be able to defer paying tax on any gain from the disposition of property if you can effect a like-kind exchange. That is, exchanging your property for another. You won't avoid the gain, just defer it until you ultimately sell the property. You've got to meet a number of requirements, principally you must identify the replacement property within 45 days after transferring the relinquished property and must actually receive the replacement property within 180 days (or, if earlier, the due date of your tax return) of the transfer of the relinquished property. In addition, both the property you're giving up and the property you're acquiring must be held for productive use in a trade or business or for investment. That means you can't do a like-kind exchange on your principal residence, your boat, etc. And the property you're exchanging must be like kind. Thus, you can trade in a drill press for an lathe, but you can't trade several computers for a truck. Fortunately, most real estate qualifies as like kind. And, if you use a qualified intermediary, you don't have to find someone willing to exchange your property for theirs. Check with your tax adviser for the details.

Normally it's clear whether the property qualifies. For example, property used in a business or a house that's rented full time qualifies. But what about your vacation home? In a 2007 case (Moore, T.C. Memo. 2007-134) the taxpayers exchanged one lake-side vacation home for another. Neither home was ever rented. Both were used by the taxpayers only for personal purposes. The taxpayers claimed that the exchange of homes was a like-kind exchange because the properties were expected to appreciate in value and thus were held for investment. The Tax Court held that the properties were held for personal use and the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.

But what if you rent the property for part of the year and also use it for personal purposes? In a Revenue Procedure (Rev. Proc. 2008-16) the IRS outlined a safe-harbor where it won't challenge whether a dwelling unit (defined as real property improved with a house, apartment, condominium or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities) qualifies as held for productive use in a trade or business or for investment.

 

Qualifying Use Standards

Relinquished property. A dwelling unit qualifies for a like-kind exchange if:

For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that date) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).

Replacement property. A dwelling unit that a taxpayer intends to be replacement property in a like-kind exchange qualifies as property held for use in a trade or business or investment if:

The first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.

 

Personal Use

For purposes of this revenue procedure, personal use of a dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes that any family member or any one unless a fair rental is charged. Rental to a family member for a fair rental if the dwelling unit is used as the individual's principal residence is not considered personal use.

 

Explanation and Example

This revenue procedure isn't an easy out if you've got a large gain on a vacation property. Clearly, if you're renting the property on a regular basis and use it for personal purposes less than 10-percent of the time it's rented or 14 days (whichever is greater), (and meet the other requirements) you now have a safe harbor. You should keep a log of your usage and the rental time. That's particularly important if you use the property at all or the rental isn't for the full year. If you work on the property (getting it ready for a summer rental, etc.) check the rules. Days working on the property may not count as personal days (there are some very strict rules as to what counts as a working day). Remember, the test is split into two 12-month periods. You can't average the usage over a 2-year period.

On the other hand, if the property is used mostly for personal purposes and you occasionally rent it to offset some costs, you're unlikely to meet the requirements of this procedure.

Example--Fred and Sue plan to exchange their vacation property on May 1, 2017. To see if they meet the vacation home test they have to go back two years. The first test period starts April 30, 2017 and goes back to May 1, 2016. The second test period starts April 30, 2016 and goes back to May 1, 2015. During the first test period they rented the property for a total of 60 days. They used the property for 5 days. They meet the test for that period since their personal usage was less than 10% of the time and less than 14 days. For the second test period they rented the property for 90 days and used it for 10 days. Since there personal usage was more than 10% in the second test period, the property won't qualify for a like-kind exchange.

If you fail the test for the oldest period, but pass the one for the most recent, you might consider putting off the exchange. And you may not have to delay the exchange for very long. In the example above they failed the test for the oldest period. If summer is the normal rental period, by delaying the exchange till October and making sure the property meets the usage requirement for the 2017 summer, the oldest, nonqualifying period won't be included in the test.

You can't insure the property is rented by really low-balling the rent. Remember, it's got to be rented for a fair rental amount. But you can get aggressive and be on the lower end of the scale, hire an agent instead of going it on your own as you might have in the past, etc.

If you don't want to, or don't think you can, rent the property for a month or two, you can meet the requirement by renting it for at least 14 days and use it less than 1 day for personal purposes.

You've also got to meet the second part of the test. The replacement property has to meet the rental and personal usage tests during the two 12-month periods after you receive the property.

Whether or not it makes sense to try and meet the tests depends on a number of factors. First, what's the amount and character of your gain? If you've got a significant capital gain or unrecaptured Section 1250 amount, putting in extra effort to qualify for a like-kind exchange generally makes sense. It makes even more sense if you'll be holding the replacement property well into the future. Finally, if you intend to leave the replacement property to your children or other relatives, you will never pay tax on the gain. And heirs won't either because of the stepped up basis in the property. Talk to your tax adviser before committing to an exchange.

 


Copyright 2016 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536


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--Last Update 05/26/16