We're taking a break from speaking about the FBAR amnesty program (we will return to this topic shortly), but were going to continue to parallel (for now) our Canadian Snowbird Blog. So the topic at hand is how do I sell my house (we're assuming the house has gone up in value), buy a new house, and not pay tax? Let's assume, for the sake of discussion, that I sell a La Quinta home which has appreciated in value by $500,000 since I bought the house in 1997.
Question #1- Can I sell the house in La Quinta (for $500k more than he bought it for) and buy the Palm Desert replacement property without paying any US tax?
The general answer is yes. Internal Revenue Code Section 1031allows me to exchange, tax free, US real property for other US real property, if several requirements are met.
Question #2- What are the general requirements for a Section 1031 exchange?
In order for me the taxpayer to exchange real property for other real property, and not pay tax:
A) The Property must be exchanged for "like-kind" property. "Like-kind" simply means that real property must be exchanged for real property. But Section 1031 also mandates both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Thus, I cannot exchange into or out of my own personal residence, because that is not deemed held for productive use in a trade or business or for investment. Vacation homes may qualify if they are rented out to unrelated persons, or held primarily for investment rather than personal use. For example, in the 2007 case of Moore v. CIR, the Tax Court held that an exchange of vacation homes did not qualify for nonrecognition under § 1031(a)(1) because neither home was held for investment: "the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence." Subsequent to the Moore case, the IRS issued Rev. Proc. 2008-16, which provides vacation properties may qualify for a 1031 if:
(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) 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.
In addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use). So if I have a vacation home for (primarily) personal use, I will have a difficult time taking advantage of Section1031 tax free exchange treatment.
B) It's not as simple as selling my property one day (let's assume for a gain), and buying a replacement property down the road, and not paying tax on the gain. First, the replacement property must be identified not later than 45 days after the sale of the first property. What does it mean to indentify a property? You identify a property in writing, giving the writing to an independent party (a qualified intermediary). Second, the replacement property must be received not later than 180 days after the sale.
We'll pick it up here in our next post, reviewing some examples of how the tax treatment works....