Getting the best tax use from a vacation home under today's rules, Part 2
This article covers the tax rules that apply when taxpayers dispose of (by selling or exchanging) vacation homes, along with some planning moves. Part 1 is available here.
Tax-free sale of vacation home
In many cases, the profitable sale of a vacation home will result in a tax-favored capital gain, although the gain will be subject to the 3.9 percent surtax on unearned income. However, some taxpayers may be able to sell their vacation homes and wind up with a profit that's partially or completely tax-free. Tax-free profits are possible where a taxpayer sells their regular home (e.g., at retirement), moves into what had been the their vacation home, and uses that property as their principal residence. If the vacation home is later sold, gain on the vacation home, as well as on the sale of the prior main home, 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.
Note that under Section 121(c) of the Tax Code, a reduced maximum exclusion may apply to taxpayers who:
1. Fail to qualify for the two-out-of-five-year ownership and use rule; or
2. Previously sold another home within the two-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 they must sell the home due to a change of place of employment, health, or to the extent provided by regs, other unforeseen circumstances. Additionally, that part of the gain attributable to depreciation claimed on the vacation home for post-May 6, 1997 periods isn't eligible for the exclusion.
The Section 121(a) rule excluding home-sale gain if the two-out-of-five-year rule is met does not apply to the extent that the gain from the sale or exchange of a principal residence is allocated to periods of nonqualified use. 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.
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 home sale gain is large enough, the seller may be able to use the full home-sale exclusion despite extensive periods of nonqualified use.
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. The taxpayer owns no other residences. If the taxpayer 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 percent 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.
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 Section 121(d)(6) (i.e., rules providing that gain attributable to post-May 6, 1997 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 Section 121(d)(6) applies.
Tax-deferred exchange of vacation home
The Tax Cuts and Jobs Act of 2017 included a major crackdown on like-like exchanges. Generally effective for transfers after Dec. 31, 2017, the Section 1031 rule permitting tax to be deferred when property is exchanged for property of a like-kind that also is held for productive use in a trade or business or for investment, applies only with respect to real property that is not held primarily for sale. Fortunately, vacation homes still may be eligible for tax-deferred exchanges. That's true despite the well-settled rule that personal residences can't be exchanged tax-free under Section 1031 because they aren't held for productive use in a trade or business or for investment.
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 Section 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 qualifies as property held for productive use in a trade or business or for investment for purposes of Section 1031 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), the taxpayer rents the dwelling unit to another person(s) at a fair rental for 14 days or more, and the period of the taxpayer's personal use of the dwelling unit doesn't exceed the greater of 14 days or 10 percent 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.
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 rented it at fair rental for 163 other days. She meets the 14-or-more rental days requirement, and the number of days on which she used the condominium for personal purposes (i.e., 16) doesn't exceed 16.3 (10 percent 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 satisfied) 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 Section 280A(d)(2) (taking into account Section 280A(d)(3) but not Section 280A(d)(4)).
Observation: Section 280A(d)(2) provides a safe harbor under which 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. 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 Section 119). Under Section 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 Section 280A(d)(4), personal use days don't include days the taxpayer used a dwelling unit as his principal residence:
- Before or after a rental (or attempted rental) period of 12 or more consecutive months beginning or ending in the tax year; or,
- 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 Section 1031. Thus, a taxpayer using the safe harbor also must satisfy all other requirements for a like-kind exchange under Section 1031 and the like-kind exchange regs.
Observation: The replacement property received in the Section 1031 exchange ultimately may qualify for the home sale exclusion if the Section 121 requirements are met. However, taxpayers who received a vacation home as replacement property in a like-kind exchange should be aware that, for purposes of computing the Section 121 exemption, any rental use of the replacement property would be considered to be a period of nonqualified use for purposes of the Section 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 Section 1031 exchange in which any gain wasn't recognized, the Section 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 five-year period beginning with the date of acquisition.
Observation: As explained above, for purposes of the Section 121(a) exclusion, Section 121(c) provides for a reduced exclusion that applies when the taxpayer does not meet the two-year ownership and use requirements by reason of a change in place of employment, health or unforeseen circumstances. Section 121(d)(10) doesn't provide a comparable exception to the five-year holding period.