Any real estate investor worth
his or her calculator is familiar with IRS code 1031. This is the tax law that
allows one to bypass the capital gains from the sale of an investment property
by purchasing a similar or more expensive investment property with the profits.
A cottage industry of lawyers, accountants and Realtors has sprung up around
1031 exchanges, which have been around since the early 1990s.
In recent years, as the second-home boom has flourished in the
U.S., many investors have sought to purchase vacation homes using the 1031
exchange. But those who do need to be careful about how they proceed. "It can
get very tricky, since the intent of code 1031 is for investment properties,"
says Nicola Gardiner, vice president of San Francisco–based Churchill Exchange,
which facilitates 1031 exchanges nationwide.
"Let’s say you own a six-unit apartment building and you sell
it and have a net profit of $500,000," says Gardiner. "Instead of paying a
capital gains tax on that, the code allows you to take that profit to buy
another investment property. This rules out using the proceeds to buy a primary
home for yourself, and the IRS considers an exclusively used vacation home to be
a luxury, so that would not qualify."
 Illustration by Michael Austin. (Click image to enlarge)
However, like much of the tax code, there are exceptions. "Say
you buy a second home in Hawaii, but you rent it out most of the year and only
use it for a few weeks. The IRS allows you a certain number of days you can stay
in your investment property each year, which varies depending on the area," she
explains. "It gets complicated, which is why you shouldn’t jump into an exchange
without having a good long talk with your tax advisor."
There is also the possibility of using a 1031 exchange to
acquire a property you will use as a vacation home down the road. "What I
have seen is people buying income properties, some of which don’t make sense
initially," says Patty Tharavej, a Realtor from Playa del Rey, Calif., who
specializes in 1031 exchanges. "They’re paying more each month on the mortgage
than they’re receiving in rent. However, they’re writing that loss off as a
business expense, and in the meantime the property is appreciating."
Besides rental property, exchanges for raw land would also
qualify under the code. "You might find a lot where you’d like to build in a few
years and that could be used, as long as you’re not building that dream vacation
home right away," says Gardiner.
More common is when someone buys a rental property using a 1031
exchange and then decides to move into it themselves. "Here’s another area where
it can be tricky," she continues. "Generally, the IRS wants to see that you had
the intent of using it as investment property. A good rule of thumb is to show
that you’ve rented it for two tax years. However, that’s another issue to take
up with your accountant."
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