With increased pressure on the federal budget, federal legislators and the IRS are examining ways to reduce tax breaks and increase tax revenues. One area being closely examined is the tax provision that allows for 1031 ‘Like Kind’ Exchanges that defer taxes on the profits from the sale of investment properties, when the sale qualifies for a 1031 exchange.

One of the provisions of the current 1031 tax code allows for the exchange of farm and agricultural properties. This category is undergoing close scrutiny and may be eliminated entirely. Another part of the 1031 tax code, the exchange of vacation or second homes is likewise being reviewed. A recent court decision that disallowed use of the 1031 exchange process for a vacation home is seen as a warning sign that such exchanges may be more closely examined in the future. With that in mind, click here for an article from Realty Times that outlines the steps a vacation homeowner should take if they want to use the second home property as part of a 1031 exchange.

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Section 1031 of the Internal Revenue Code provides great tax benefits for qualifying property owners. Savvy users can build wealth by using untaxed gains to reinvest in more valuable property. But careful planning should be observed if you want to use this tax option. It is not a do it yourself process.

The IRS has established specific rules that must be followed. The service of a qualifying intermediary (QI) is required to hold the property and money until the exchange is completed.

• Do understand all the rules and follow them
• Do establish a rental history for vacation homes (minimum of 2 years, 5 is best)
• Do document any change from ‘personal’ use to ‘rental use’
• Do consult with a tax attorney, accountant and a QI
• Do have the QI hold all the money until the exchange is complete
• Do be sure that the replacement property is deeded to the same person as the relinquished property
• Do identify the replacement property within 45 days of the date of transfer of property being relinquished
• Do complete the exchange within 180 days of transfer of the relinquished property.

• Do Not use a home for personal use more than 14 days(or ten percent of annual total occupied days) for the first year (two or more is safer)
• Do Not select a replacement property that is more expensive than the relinquished one or be prepared to pay taxes on the gain
• Do Not use anyone other than a QI to do the transaction
• Do Not take proceeds before the exchange is completed
• Do Not use the purchase for immediate sale (read flipping) – does not qualify, vs. investment – does qualify.

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Section 1031 Exchanges can be used to defer tax on the sale of a property that was held for investment when purchasing another investment property. But, there are a lot of regulations and rules that need to be met in order to qualify for the tax benefits available with a 1031 Exchange.

The Federation of Exchange Accommodators has a great FAQ page with answers to many of the most common questions regarding 1031 Exchanges.

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