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Question: I have owned and rented a house in the South since 1989, and plan to sell it as part of a section 1031 Starker exchange. I am seriously considering purchasing a beach house in Virginia, which I intend to rent during the summer months and also use it for 14 days or less during the year.

Am I permitted under the 1031 tax laws to exchange a rental unit for a vacation home?

Answer: The answer depends on how you use that vacation home.

Let's first review the rules for a Starker exchange.

If you sell your principal residence, and you have lived and owned it for two out of the previous five years before it is sold, the tax law permits you to completely exclude from taxation up to $250,000 of profit (or up to $500,000 if you are married and file a joint income tax return).

On the other hand, if you are selling investment property, you will have to pay capital gains tax, which under current federal law is 15 percent of the profit. However, if you arrange to exchange -- rather than sell -- the investment property, section 1031 of the Internal Revenue Code allows you to defer the profit you have made.

The property you sell is called the "relinquished property." The new property is called the "replacement property."

Let's take this example. You purchased a house back in the l980's for $100,000, and it is now worth $600,000. Forgetting for this discussion expenses or improvements (all of which come into play when determining profit), you have made a gain of $500,000. Should you sell the house, the IRS will require you to pay $75,000 in capital gains tax. And the state in which you reside may also have a tax on this profit.

You decide that you want to engage in a 1031 exchange. Such an exchange is also referred to as a "Starker" exchange, based on an important legal case involving Mr. Starker. You sell the relinquished property. All of the net sales proceeds are held by a third party -- called an "intermediary."

Within 45 days from the day the relinquished property is sold, you must identify the replacement property and advise the intermediary of your decision. You can identify – and indeed obtain – up to three replacement properties. If more than three such properties are identified, the collective value of these properties cannot exceed 200 percent of the value of the relinquished property unless at least 95 percent in value of the identified properties are actually purchased.

The replacement property must be equal or greater in price than the selling price of the relinquished property. Otherwise you will have to pay tax -- called "boot" -- on the difference between the two properties.

In our example, you obtain the replacement property for $600,000. All of the cash from the relinquished property must go directly into that new property. You are not able to control or use the sales proceeds for any purpose other than to buy the replacement property.

Keep in mind that a Starker exchange is not a "tax-free" arrangement; you have correctly described it as a "tax-deferred" process. Why? Because although you have paid $600,000 for the new property, the tax basis of the relinquished property becomes the basis of the replacement property. Thus, when you ultimately sell the replacement property, and do not engage in another Starker exchange, you will have to pay all of the capital gains tax that you had previously deferred.

What kind of property is eligible for a 1031 exchange? The law requires that the property be "like-kind." In other words, you must exchange real estate for real estate. You can exchange a single family house for a farm, an office building, a condominium (or cooperative) unit, or even a vacant lot or raw land. The bottom line is that you must exchange one piece of investment property for another investment.

Does a vacation home meet the "like-kind" test? Here, we have to look to another section of the IRS Code, namely section 280A. Under the law, if an individual (or a subchapter S corporation) uses any property for less than 14 days per year -- or ten percent of the number of days the property is rented -- the taxpayer does not have to report any of the rental income and cannot deduct any expenses as rental expenses.

According to the IRS:

You must first consider if you use your dwelling as a home. You are considered to use a dwelling as a home if you use it for personal purposes during the tax year for more than the greater of 14 days or 10 percent of the total days it is rented to others at a fair rental price. It is possible that you will use more than one dwelling unit as a home during the year. For example, if you live in your main home for 11 months and in your vacation home for 30 days, your home is a dwelling unit and your vacation home is also a dwelling unit, unless you rent your vacation home to others at a fair rental value for more than 300 days during the year.

Thus, since you plan to use the beach house for less than 14 days a year, the IRS does not treat this as a home and it is possible that the beach house would qualify as "like-kind" exchange property. I use the word "possible" because there do not appear to be any court cases or IRS rulings on this issue.

To be on the safe side, you may want to consider avoiding any personal use of the beach house for at least two years. The IRS might take the position that any personal use defeats the requirement under the 1031 requirements that the replacement property be for "investment" purposes.

For additional information, go to the IRS website and refer to Tax Topic 415, Renting Vacation Property/Renting to Relatives and Publication 527 , Residential Rental Property (including Rental of Vacation Homes).

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