Making The Best Tax Use Of a Vacation Home Under Today’s Rules-Part II

Making The Best Tax Use Of a Vacation Home Under Today’s Rules-Part II

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Federal Taxes Weekly Alert Newsletter

Preview Documents for the week of 05/28/2015 – Volume 61, No. 22

Articles

Making the best tax use of a vacation home under today’s rules-Part II

An improved economy, strengthened real estate market in many areas, and a favorable interest rate

environment has led to a resurgence of interest in vacation or second homes. These properties offer a

chance to provide the family with a place to rest and relax at a reduced cost when compared to

expensive short-term resort rentals, and at the same time give owners a shot at capital appreciation over

the long term. They also offer a chance to earn some rental income when the owner or family members

aren’t using the property. This second installment of a 2-part Practice Alert reviews today’s tax rules that

apply when taxpayers dispose of (by selling or exchanging) vacation homes and suggests some

planning moves. The first installment ( ¶ 8 ) covers the rules that apply to vacation homes that are rented

to others during the year.

 

Tax-Free Sale of Vacation Home

A taxpayer may sell his regular home at retirement and move into what had been his vacation home. If

the vacation home is later sold, gain on the sale of both homes is eligible for the up-to-$250,000

exclusion ($500,000 for qualifying married taxpayers) if each is owned and used as a principal residence

for at least two of the five years preceding the sale date of each home, and two years elapse between

the sales. ( Code Sec. 121(a) , Code Sec. 121(b)(3) ) Note that under Code Sec. 121(c) , a reduced

maximum exclusion may apply to taxpayers who (1) fail to qualify for the 2-out-of-5-year ownership and

use rule, or (2) previously sold another home within the 2-year period ending on the sale date of the

current home in a transaction to which the exclusion applied. That reduced maximum exclusion rule

applies if the taxpayer’s failure to meet either rule occurs because he must sell the home due to a

change of place of employment, health, or to the extent provided by regs, other unforeseen

circumstances.

That part of the gain attributable to depreciation for post-May 6, ’97 periods isn’t eligible for the

exclusion. ( Code Sec. 121(d)(6) )

 

Reduced homesale exclusion for nonqualified use. The Code Sec. 121(a) rule excluding homesale

gain if the two-out-of-five-year rule is met won’t apply to the extent gain from the sale or exchange of a

principal residence is allocated to periods of nonqualified use. ( Code Sec. 121(b)(5) ) Generally,

nonqualified use is any period (other than the portion of any period before Jan. 1, 2009) during which the

property is not used as the principal residence of the taxpayer or spouse. For example, use of a

residence as a vacation home or as rental property is nonqualified use.

RIA observation: It’s important to note that the exclusion isn’t reduced for nonqualified use;

rather, it’s the gain potentially eligible for the exclusion. Thus, if the homesale gain is large enough,

the seller may be able to use the full homesale exclusion despite extensive periods of nonqualified

use.

RIA illustration A single taxpayer buys a residence this year, uses it as a vacation home for

four years, and then uses it as a principal residence for four years. He owns no other residences. If

he subsequently sells the home and realizes a gain of $500,000, half of the gain will be allocable to

nonqualifying use and subject to tax as long-term capital gain (and the 3.9% surtax on unearned

income), but the other half will qualify for the full $250,000 homesale exclusion.

The amount of gain allocated to periods of nonqualified use is the total amount of gain multiplied by a

fraction (1) the numerator of which is the aggregate periods of nonqualified use during the period the

property was owned by the taxpayer, and (2) the denominator of which is the period the taxpayer owned

the property. ( Code Sec. 121(b)(5)(B) )

For determining the amount of gain allocated to nonqualified use of a principal residence,:

. . . the rule providing that gain allocated to periods of nonqualified use does not qualify for the

exclusion is applied after the application of Code Sec. 121(d)(6) (rules providing that gain

attributable to post-May 6, ’97 depreciation does not qualify for the exclusion), and

. . . the rules providing for the allocation of gain to periods of nonqualified use are applied

without regard to any gain to which Code Sec. 121(d)(6) applies. ( Code Sec. 121(b)(5)(D) )

 

Tax-Deferred Exchange of Vacation Home

Under Code Sec. 1031 , no gain or loss is recognized on the exchange of property held for productive

use in a trade or business or for investment if the property is exchanged solely for property of like kind

that is to be held either for productive use in a trade or business or for investment. Property held for

productive use in a trade or business may be swapped for property held for investment, and property

held for investment may be swapped for property held for productive use in a trade or business. ( Reg. §

1.1031(a)-1(a)(1) )

It’s well settled that personal residences can’t be exchanged tax-free under Code Sec. 1031 because

they aren’t held for productive use in a trade or business or for investment. However, under Rev Proc

2008-16, 2008-1 CB 547 , a safe harbor applies under which a dwelling unit (real property improved

with a house, apartment, condominium, or similar improvement that provides basic living

accommodations including sleeping space, bathroom and cooking facilities) will qualify as property held

for productive use in a trade or business or for investment for Code Sec. 1031 purposes even though it is occasionally used for personal purposes.

More specifically, under Rev Proc 2008-16 , IRS won’t challenge on personal use grounds whether a

dwelling unit is relinquished or replacement property under the Code Sec. 1031 rule requiring such

property to be held for productive use in a trade or business or for investment if:

. . . the taxpayer owns the property for the qualifying use period (for relinquished property, at

least 24 months immediately before the exchange; for replacement property, at least 24

months immediately after the exchange); and

. . . within the qualifying use period, in each of the two 12-month periods immediately

preceding the exchange (in the case of relinquished property) or immediately after the

exchange (in the case of replacement property), (i) the taxpayer rents the dwelling unit to

another person(s) at a fair rental for 14 days or more, and (ii) the period of the taxpayer’s

personal use of the dwelling unit doesn’t exceed the greater of 14 days or 10% of the number

of days during the 12-month period that the dwelling unit is rented at a fair rental.

For relinquished property, the first 12-month period immediately preceding the exchange ends on the

day before the exchange takes place (and begins 12 months before that day), and the second 12-month

period ends on the day before the first 12-month period begins (and begins 12 months before that day).

For replacement property, 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.

RIA illustration Tina owns a beach condominium (relinquished property) that she intends to

exchange in a tax-free like-kind exchange for a lake house (replacement property). Tina has

owned the condominium for five years before the exchange. During each of the two 12-month

periods immediately preceding the exchange, she used the condominium for personal purposes for

16 days and rents it at fair rental for 163 other days. She meets the 14-or-more rental days

requirement. The number of days on which she used the condominium for personal purposes (i.e.,

16) doesn’t exceed 16.3 (10% of 163, the number of other days on which the home is rented at a

fair rental). Thus, Tina’s personal use of the condominium also meets the use test for purposes of

the safe harbor.

If she also satisfies the safe harbor’s ownership and usage periods for the lake house

(replacement property), the swap transaction will be treated as a like-kind exchange (assuming all

the other conditions are satisified) even if Tina subsequently uses that property strictly as a

personal residence.

Personal use occurs on any day on which a taxpayer is treated as having used the dwelling unit for

personal purposes under Code Sec. 280A(d)(2) (taking into account Code Sec. 280A(d)(3) but not

Code Sec. 280A(d)(4) ).

RIA observation: Under Code Sec. 280A(d)(2) , a taxpayer is treated as using a dwelling

unit for personal purposes for a day if the unit is used for personal purposes by: (1) the taxpayer or

any other person who has an interest in the dwelling unit or by a member of the family of the

taxpayer or the other person; (2) any individual who uses the unit under a reciprocal use

arrangement (other than use by a person having an equity interest in the property under a shared

equity financing agreement); or (3) by any individual unless for that day the dwelling unit is rented

for a fair rental (an individual’s use doesn’t count if the value of the use is excludable from the

individual’s gross income under Code Sec. 119 ). Under Code Sec. 280A(d)(3) , a taxpayer is not

treated as using a dwelling unit for personal reasons if the unit is rented out or held for rental at a

fair rental to any person for use as a personal residence. And under Code Sec. 280A(d)(4) ,

personal use days don’t include days the taxpayer used a dwelling unit as his principal residence:

(1) before or after a rental (or attempted rental) period of 12 or more consecutive months beginning

or ending in the tax year; or (2) before a consecutive rental (or attempted rental) period of less than

12 months beginning in the tax year, at the end of which the residence is sold or exchanged.

The safe harbor applies only to the determination of whether a dwelling unit is held for productive use in

a trade or business or for investment under Code Sec. 1031 . Thus, a taxpayer using the safe harbor

also must satisfy all other requirements for a like-kind exchange under Code Sec. 1031 and the

like-kind exchange regs.

RIA observation: The replacement property received in the Code Sec. 1031 exchange

ultimately may qualify for the home sale exclusion if the Code Sec. 121 requirements are met.

However, taxpayers who received a vacation home as replacement property in a like-kind

exchange should be aware that any rental use of the replacement property would be considered to

be a period of nonqualified use on a later sale or exchange of the residence for purposes of the

Code Sec. 121(b)(5) rule (see above) denying the home-sale exclusion for periods of nonqualified

use.

Taxpayers also should be aware that if they acquire a home in a Code Sec. 1031 exchange in which

any gain wasn’t recognized, the Code Sec. 121 exclusion does not apply to the sale of the home by the

taxpayer (or by any person whose basis in the property is determined, in whole or in part, by reference to

the basis in the hands of the taxpayer) for the 5-year period beginning with the date of acquisition. (Code Sec. 121(d)(10) )

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