For many individuals, the sale and replacement of a second home will incur capital gains taxes. The good news is that, if appropriate rules are followed, these homeowners can benefit from the tax-deferral benefit of a 1031 exchange.
The rules governing such transactions are explained in Revenue Procedure 2008-16. Here the IRS offers clarification to a previously confusing section of 1031 code. As of March 10, 2008, vacation home exchanges will qualify if all of the following are met:
- The owner must have held the vacation home for at least 24 months prior to the exchange.
- For each 12-month period preceding the exchange, the vacation home must have been rented to a third-party at fair market value for 14 days or longer, and
- The owner can not have used the vacation home for personal use for the greater of 14 days or 10% of the time the home was rented to third-parties at fair market value.
- The owner must hold the new property for at least 24 months* after the exchange takes place.
- For each of those 12 month periods, the property must be rented out to a third-party at fair market value for at least 14 days or more, and
- The owner cannot use the vacation home for more than 14 days or 10% of the time it is rented at fair market value to a third-party.
When it comes to determining whether the rental price meets the IRS definition of fair market value, Revenue Procedure 2008-16 offers this:
For purposes of this revenue procedure, whether a dwelling is rented at a fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the parties to the rental agreement are taken into account.