Let’s say you are selling your vacation home, which you use for personal purposes and also rent out to third parties. A pretty common setup. If you buy a new vacation home, can you defer the recognition of your gain on the sale? If so, how? To find out, we asked Bruce Bell, an attorney at the Chicago office of Schoenberg Finkel Beederman Bell Glazer.
Larry Light: How does this work tax-wise?
Bruce Bell: The Internal Revenue Code permits taxpayers to defer gains on real estate sales used for business or investment purposes, if the proceeds are reinvested in other real estate business or investment properties. There are rules to avoid full gain recognition: all cash from the sale must be reinvested in the replacement property, and, generally speaking, the acquisition of the new property must occur within 180 days from the date of the sale of the relinquished property.
Light: What other steps do you need to take?
Bell: To see if you qualify for tax deferral, count the number of days the home is rented out and used for personal purposes. You must own the property you sell for at least 24 months before the date of the sale, called a look-back period.
Also, the home must be rented at fair market value for 14 days or more during each of the two 12-month time periods immediately preceding the sale. Plus, your personal use of the home during this time period must not exceed the greater of 14 days or 10% of the number of days the home is rented at market rates.
Light: What about times when you aren’t in residence there and the place isn’t rented out?
Bell: Days where the property is vacant and available for rental are not treated as personal use days. The same goes for days where the property is being repaired or improved, which are not treated as rental days. You must be able to document all this.
Light: What else?
Bell: 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.
Light: How hard and fast are these safe harbor rules?
Bell: The safe harbor is an IRS guideline which, if satisfied, will assure you the IRS will not challenge the exchange. 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 won’t challenge your deferral of gain on the sale of the property.