Second Home Secrets
By Bob Hartwick

The American Dream for many is home ownership. Some downstate residents take this one step further: a vacation home on one of our pristine lakes or golf courses. Although the luxury of having a second home in a vacation wonderland such as our area is appealing, the tax implications upon its sale are not. The following is a brief overview of the tax aspects of owning and selling a vacation home and what may be done to avoid capital gains tax upon disposition.

Selling a second home/vacation home for profit is going to cost its owner money in taxes to Uncle Sam! Property owners selling this type of property are not provided with a means of deferring or excluding capital gain realized due to an increase in the property's value. There are, however, ways of minimizing the impact.

Internal Revenue Code Section 280A contains certain exceptions that provide second homeowners a means to tax-plan and potentially avoid capital gains tax should they decide to sell. Section 280A(a) states that "n[o] deductions otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the year as a residence." This home business expense rule generally disallows any expense deductions with respect to a "dwelling unit" used by a taxpayer as a residence, unless such use falls within the exceptions that permit deduction of expenses attributable to business use of a home. The traditional rule is personal living expenses are not deductible, except to the extent of nonbusiness deductions, such as interest and taxes. Vacation and second homes fall within this category.

Conversion of a vacation home to an investment property is a nontaxable event. A vacation home may qualify as business property if personal use is minimal. This means you can occupy a rental property for a minimum of 14 days without altering its character to personal use property. Or, you may use the property 10 percent of the number of days during the year the property is rented at a fair rental rate. For example, if a property was rented for 250 days during a year, then it can be used for personal use for up to 25 days. Those days used above 25 must be accounted for and the attributed percentage amount subtracted from the business expense deductions for the year. This rule allows taxpayers some minimal use of a property, but still requires the majority to be rental.

A property held for productive use in a trade or business or for investment can be exchanged for like kind replacement property of equal or greater value under Internal Revenue Code 1031. The gain realized from the sale can be deferred to the replacement property through the use of a qualified Intermediary. A taxpayer anticipating the sale of a second home or vacation home can covert it use to rental property in order to take advantage of the tax-deferred exchange. Renting the property or holding it available for rent for a minimum of one year should be sufficient to meet the criteria of conversion to business property as it qualifies the property as being held as a capital asset. However, there is nothing in the Tax Code or Treasury Regulations that stipulates how long is long enough. Consider the caveat, "the longer the better". Once the property has taken on the characteristics of a rental, a taxpayer can then exchange this property for like kind replacement property (e.g. another rental property, a lot, etc.) and defer payment of capital gains tax.

Conversely, second homes or vacation homes can be converted to a principal residence instead of rental property giving taxpayers another potential method that allows no recognition of capital gains tax. Moving onto the property and occupying it for a minimum of two years as a principal residence will accomplish this. Upon its sale, the new IRC 121 exclusion of up to $250,000 in capital gains, if single, $500,000, if married, from the sale of a principal residence becomes controlling. Provided the taxpayer had not used this exclusion allowance within the previous 24 months, any gain realized upon the sale up to the maximum limits would be excluded from income.

Whenever employing any of the above techniques, it is always advisable to check with your accountant before proceeding. With advise from tax counsel and proper planning, a second home or vacation home can still be sold without costing its owner a fortune in taxes.

This is the last in a series of four articles to be published on Tax Deferred Exchanges. Bob Hartwick is an associate Broker with RE/MAX of Petoskey and has been involved with resort property sales for over twelve years. This material is provided for informational purposes only and is not to be construed as tax advice. The reader is strongly advised to speak with a tax consultant before attempting to employ any of the concepts stated herein.

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Free Tax-Deferred Exchange Information
Did you know that there is a reverse 1031 Exchange, where an investor acquires the replacement property before closing on the relinquished property? Did you know that an investor could trade out of one property into several, or consolidate from smaller properties into one larger property?

Most people don't take advantage of a Tax-Deferred Exchange because they believe it is too difficult or they obtained incorrect information.