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Swapping vacation homes? Sail into new safe harbor

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in Small Business Tax,Small Business Tax Deduction Strategies

The housing market slump has extended to owners of vacation homes, and in most parts of the country, it may be hard to obtain a reasonable price for a place you’ve owned for some time.

Strategy: Trade your vacation home for comparable properties. So long as you meet the tax law requirements for a “like-kind exchange,” you can avoid any current tax liability on the deal.

The key is to ensure that both vacation homes qualify as investment property. In the past, that would have been a tall order.

But now, the IRS has approved a new safe-harbor rule for vacation homeowners. (IRS Revenue Procedure 2008-16) Simply follow the new guidelines and you’re in the clear. (See background information on like-kind exchanges in SBTS, January 2008.)

When it comes to exchanging second homes—such as a vacation home in the mountains for one near the beach—the IRS traditionally has taken a dim view of the proceedings. It often treats such homes as personal assets, even if they are offered for rental part of the time. The Tax Court sided with the IRS on this issue last year. (Moore, TC Memo 2007-134)

New safe-harbor rule: Now the IRS has changed tactics. In the new ruling, it says that a vacation home constitutes investment property if it satisfies a specific test. For this purpose, a “vacation home” may be a house, condominium or similar dwelling that provides basic living accommodations including sleeping space, bathroom and cooking facilities.

There are two main parts to the test:

1. The relinquished property must be owned by the taxpayer for at least 24 months before the exchange, and the replacement property must be owned for at least 24 months after that exchange.

2. For both of the two 12-month periods immediately preceding the exchange, you must:
  • Rent the home at a fair rental price for 14 days or more; and
  • Keep your personal use of the home below the greater of 14 days or 10% of the number of days that the home is rented at a fair rental price.
Does the 14 days/10% part of the test sound familiar? It should. This is the same formula used to determine personal use for purposes of rental expense deductions. But there’s a critical difference here: Instead of being applied on an annual basis, the safe-harbor rule covers each of the two 12-month periods before the like-kind exchange. It’s likely that these time periods will straddle different tax years.

The ruling finally carves out distinct boundaries for homeowners. Now you know exactly how much personal use you’re allowed without jeopardizing a like-kind exchange. But the IRS still could nix swaps where you show minimal effort to treat a place as investment property.

Tip: Don’t forget you must hold the replacement property for at least 24 months after the exchange, and you must meet the same rental/personal use standards for the two 12-month periods following the swap.

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