• Avoid Taxes by Entering into a Cottage 1031 Safe Harbor
  • October 23, 2014 | Author: Kate E. Flewelling
  • Law Firm: Smith Haughey Rice & Roegge, P.C. - Traverse City Office
  • 1031 exchanges are often considered by real estate investors when they look to cash out of an investment. Generally speaking, a 1031 exchange (also referred to as a “like-kind exchange”) is a swap of one business or investment asset for a similar asset. For example, you own asset X, which you bought for $10 and are now going to sell for $100; you want to take that $100 and invest it in similar asset Y. If you comply with the requirements of Internal Revenue Code (IRC) 1031, the IRS will let you sell X and buy Y and defer capital gains tax on the $90 in gain that you had from the sale of asset X. Therefore, if you meet the requirements for a 1031 exchange, which are many and complicated, you are able to change the form of your investment without recognizing a capital gain, allowing your initial investment to continue to grow tax-deferred in its new incarnation.

    In recent years, as real estate markets have begun rebounding and even booming, it has become more common for owners of property to look for ways to avoid recognizing gains on sale.

    When you sell your primary home, assuming you meet certain residency and ownership criteria, you, combined with your spouse, do not have to pay capital gains tax on the first $500,000 in gain, per IRC Section 121. That exemption, however, does not apply to second homes, which leaves many vacation homeowners looking for avenues to avoid taxes on the sale of such properties.

    A 1031 exchange may be the answer for those vacation homeowners; however, starting in 2004 and continuing through 2008 and beyond, Congress and the IRS have consistently narrowed the scope of allowable 1031 exchanges as they relate to residential real estate. These exchanges are not available for all residential property; only “property held for productive use in a trade or business or for investment,” but how you determine whether a property is held of investment or for personal use is a difficult calculation and facing increasing scrutiny by the IRS.

    In 2004 Congress started to limit the use of 1031 exchanges involving residential property by changing the ownership requirements for residential property involved in like-kind exchanges to require a longer holding period between acquiring a residential property in a like-kind exchange, converting it to personal use and then selling it with an IRC section 121 capital gains exemption.

    Then, in 2008, addressing the uncertainty around “investment” residential property and arguably wanting to limit the use of 1031 exchanges, the IRS issued a revenue ruling that established a safe harbor for “when it will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of § 1031 of the Internal Revenue Code.”

    To fit into what we will refer to as the “Cottage 1031 Safe Harbor,” you must meet the following criteria with respect to relinquished property (i.e., the property you are selling):

    • The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the “qualifying use period”); and
    • Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
      • The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
      • The period of the taxpayer’s personal use of the dwelling unit does not 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.

    You must also meet the following criteria with respect to your replacement property ( i.e., the property you are buying):

    • The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and
    • Within the qualifying use period, in each of the two 12-month periods immediately after the exchange,
      • The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
      • The period of the taxpayer’s personal use of the dwelling unit does not 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.

    The takeaway is that you will not fit in the safe harbor unless you actually devote your current property to a rental use for the last two years of your ownership and then devote the new property to a rental use for an additional two years. Although the required rental periods are not lengthy, rent should be set at fair market rent even if the renters are family or friends. Also remember that, should you want to sell the replacement property as a personal residence in order to obtain a 121 exemption, you will need to wait at least five years from acquisition and meet all other criteria for such exemption. Therefore, the use of 1031 to defer capital gains on appreciated cottages is still available, but it requires a significant amount of advance planning and limited personal use of your asset (no more than 14 days per year) for an extended period of time.