This just in: The IRS says that you can avoid a capital gains tax hit by swapping your vacation home instead of selling it. Just make sure that you follow the rules to qualify.

Sometimes the IRS does nice things for you. And that's no joke: Tax legislators recently showed their softer side by clarifying the rules pertaining to tax-free 1031 exchanges. The new rules may give you the opportunity you need to get rid of your vacation home without taking a big tax hit.

Clear as mud

If you own appreciated investment and business property, you can complete a 1031 exchange to unload that property without incurring taxable capital gains. To qualify for the tax benefits, you must trade one property for another, rolling the entire untaxed gains earned on the first property into the second property. You're prohibited from pulling cash out of the deal, nor can you take on a smaller mortgage than the one taken out by the new owner of the property you traded away.

There are a host of requirements to fulfill, but the successful 1031 exchange results in a full tax deferral, where the gains earned on the first property adjust the cost basis of the second property downward. A sale of the second property for cash would be a taxable event, but you could do another 1031 exchange to defer the tax hit even longer.

As if this isn't convoluted enough, there's the question of what qualifies as business or investment property. For example, is a home that you sometimes rent out and sometimes stay in considered a business or investment property? As of March 10, 2008, the answer to this question is yes, you can complete a 1031 exchange and defer taxes on your mixed-use vacation home.

Hoops to jump through

The 1031 exchange is a complicated animal, particularly with respect to mixed-use vacation homes. Here are some of the requirements:

  • You must have owned the first property for at least the two years preceding the exchange.
  • You must have rented out the property for a minimum of two weeks during each of the two 12-month periods preceding the exchange. Also, the rent you charge has to be a reasonable market rate-so renting the house to your brother for $25 a night doesn't count.
  • During each of the two 12-month periods preceding the exchange, your personal use of the property is limited to 14 days or 10 percent of the days that you rented out the property-whichever is greater.
  • Personal use includes your use of the property, as well as use by anyone who's not paying a market rental rate.

If you can fulfill these particulars, a 1031 exchange may be the right way to disown your vacation property. Just make sure that you have an experienced tax advisor help you with the transaction, because the worst thing you can do is break your newfound friendship with the IRS.

Published on July 27, 2008