Housing Counsel: Swapping Properties - What is "Like Kind"?

"Am I permitted under the 1031 exchange laws to swap a rental unit for a "vacation home"?
By: Benny L. Kass: RealtyTimes
In other words, is this considered a "like-kind" exchange?"

Question: I have rented a house in Texas for more than 10 years and would like to sell it as part of a 1031 Starker tax-free exchange. I plan to sell my house and purchase a rental unit near Virginia Beach. I have never occupied or used the Texas property and have exclusively rented it to various tenants over the years. My gross income has substantially increased over the years, thereby reducing the tax benefits of owning this rental property. I intend to rent the replacement property "beach" house during the summer months and also use it for 14 days or less during the rest of the year.

Am I permitted under the 1031 exchange laws to swap a rental unit for a "vacation home"? In other words, is this considered a "like-kind" exchange?

Answer: The specific answer depends on the use which you plan for the vacation home.

But first, I want to correct a misstatement in your question. Section 1031 of the Internal Revenue Code is the operative section which permits the so-called "Starker exchange." You referred to it as a "tax free" exchange. This is not accurate. As has often been said, "Death and taxes are the only certainty in life".

A Starker - 1031 exchange is not tax-free. It is best described as a "tax-deferred" transaction. When you sell your Texas house - which is called the "relinquished property" - the profit which you have made will be taxed at the Federal capital gains tax rate, which currently is 15 percent. You may also have to pay the applicable State or local tax. However, if you arrange to "exchange" the Texas property, and comply with all of the legal requirements for a 1031 exchange, the tax which you would have paid is deferred.

Let's look at this example. You purchased the Texas property for $50,000. You will sell it for $350,000. For purposes of this example, we will ignore depreciation and any improvements which you have made. Your profit is $300,000. If you do not do a 1031 exchange transaction, you will have to pay the IRS $45,000 in capital gains tax.

However, if you exchange the property, and purchase a replacement property for $400,000, you will not have to pay the tax at this time. But the law does not give you a complete break. Even though you will pay $400,000 for the new property, the basis of the relinquished property becomes the basis of the replacement property - i.e. $50,000. Basis is defined as the original cost of the property, plus any improvements which you have made during the period of ownership.

Thus, when you go to sell the replacement property later, unless you engage in yet another 1031 exchange, you will ultimately have to pay the capital gains tax on all of the profit you have made. In our example, if you sell the replacement property for $550,000, your profit is $500,000 ($550,000 - 50,000), even though you paid $400,000 for that real estate.

Now back to your question. There is no statutory definition of "like-kind." However, the IRS and the Tax Court have made it clear that the replacement property has to be real estate. This means that you can swap your Texas single family home for another such property, or any other kind of real estate. A house can be exchanged for an office building; a condominium unit can be exchanged for a vacant lot. A shopping mall can be exchanged for a farm. So long as the replacement property is real estate, it will pass muster with the IRS.

But a vacation home creates potential problems. In order to have a successful 1031 exchange, the law requires that both the relinquished and the replacement property be "held for productive use in a trade or business or for investment."

Another section of the tax code (Section280A) creates special rules dealing with such properties. If the vacation home is not used by the taxpayer for personal purposes for the greater of (a) more than 14 days during the tax year or (b) more than 10 percent of the number of days during the year in which the property is rented out, it is considered investment property. Accordingly, you may be able to acquire the Virginia Beach property as the replacement property in your 1031 exchange.

However, it is my understanding that there are no reported court cases dealing with this issue. Thus, it is possible that some IRS auditor may consider that your personal use of the property -- albeit less than 14 days and in compliance with Section 280A - defeats the investment purpose and would not honor the exchange.

Your best bet: at least for two years, do not use the Virginia beach property at all, so it truly will be rental property.

Keep in mind that when you sell the relinquished property, you must identify the replacement property within 45 days from the date of its sale, and you must actually take title to that property at the earlier of 180 days from the sale date, or when your income tax return for the year in which the property is sold is due. These are mandatory deadlines spelled out in the law, and cannot be waived.

A 1031 exchange is a valuable tool for any investment property, but must be done properly. Consult your tax and legal advisors before you make any commitments or sign any real estate contracts.