How to Buy a Vacation Home With an IRA 1031 Exchange
Section 1031 of the Internal Revenue Code provides for the tax-deferred exchange of investment properties. That complicates the task of acquiring vacation property using such an exchange, but does not make it impossible. If you are planning such a 1031 exchange, do it with investment properties that you occasionally use yourself, under the careful guidance of real estate professionals.
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Instructions
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Understand what a 1031 exchange is. "In a typical transaction, the property owner is taxed on any gain realized from the sale," says the Federation of Exchange Accommodators (FEA), the organization of professionals who handle 1031s. "However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date."
Done correctly, a 1031 exchange allows a property seller to defer the taxes on the appreciation of his property by buying a similar, but more expensive, property within certain strict limitations and timetables.
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Understand what a 1031 is not. It is not a way to defer taxes on selling your house, either your primary residence or a vacation home. A "vacation home" bought via a 1031 exchange must actually be a bona fide investment property -- something you use for yourself in only a limited way.
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Make sure that the property you are selling counts as an investment property. "The trick then is to differentiate your property from purely personal enjoyment, and cast it, or document it, as investment property," says Gary Gorman, a 1031 exchange expert. He recommends that you not use the property more than two weeks a year, lease it when you're not there -- a local management company can handle that -- and keep detailed records.
Perhaps most importantly, consult with a real estate attorney to make sure you're following the rules, and that your property qualifies as an investment property. If the IRS thinks otherwise, you'll pay for your mistake.
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Execute the 1031 exchange. The professional who facilitates such an exchange is called a qualified intermediary (QI). It's important to have a reputable QI because, as the FEA notes, "the use of a QI is a safe harbor established by the Treasury Regulations. If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds."
The QI receives the funds from the sale of the original property, then turns the funds over to the seller of the replacement property. Because you have never received the proceeds of the sale, as far as the IRS is concerned, you don't owe taxes on it.
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Meet the deadlines. To defer taxes on the sale of your property, you must identify a possible replacement property within 45 days. (Wait 46, and you'll have a tax liability.) After it's identified, a replacement property must be purchased within 180 days, or likewise there will be a large tax liability.
In meeting these deadlines, a wise seller needs the help of both a QI and a real estate broker who can help the seller find and close on a property within the specified periods.
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Tips & Warnings
Keep all documentation regarding your investment property. Get professional advice -- a real estate attorney, in particular.
References
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