Century 21 Island Life
Robert U. Valenzuela, P.A.
A New Ownership Strategy For Second Homes

Some housing markets are on the upswing.

Most everyone loves the chance to get away from it all . . . Come home from work, pull on some comfy jeans, stick the cell phone in the desk drawer, pack the trusty fishing pole (skis, surfboard, paperback, etc.) and simply slip away to a place all your own.

But not everyone can stash hard-earned savings into a weekend getaway for a family retreat. How can you possibly fund college tuitions, high school proms, family cars, business seminars, plus manage a payment on a second home?

Let’s step back a moment from the traditional concept of acquiring a second home and consider different roads to get there. For example, let’s see how we can arrive at the doorstep of a family retreat by purchasing one additional piece of real estate – run-down fixer, commercial building, vacant lot, attractive duplex – anywhere in the country. Let’s find a piece where tenants pay down your mortgage and the property also gains appreciation; then trade that property for a place located where you always wanted to spend your time. If you are looking for the fastest way is to make it work without swallowing all the costs by yourself, consider this shortcut.

  • Find a property in the area (canal front, beach front, ocean front, bay front, dry lot, vacant land) where you would like to spend your leisure time. Make the down payment with savings or a home equity loan on your principal residence.
  • Rent it out for most of the year – renters pay down your mortgage. Enjoy some personal use days and get to know the area.
  • In a few years, if you like the area and have more time to enjoy the home, deem it your second home. You could even sell your primary residence, pocket the $500,000 gain ($250,000 for single people) and make your second home your primary residence.
  • If the area does not suit you, keep the home as investment property and “trade” it via a Section 1031 Tax Exchange, sometimes known as a Starker Exchange, and find another investment property in a different area.

A second home can also be a long-term tax shelter for future retirement. For example, if you are 39-years old and plan to slow down at 57, you can buy a rental home disguised as vacation home, furnish it, enjoy some personal use time, and have renters pay for it. When you have whittled every shred of tax advantage out of it, you can move in and convert it to a full-time private residence while still renting it out a couple of weeks a year. And because most mortgages ``front-loan'' interest, you will have used up most of your tax deductions from the mortgage in the 18 years you were working and renting the home. In the later years of the mortgage, when interest deductions are relatively low, you probably will be less concerned because your income will have fallen off because you have promised yourself to slow down at age 57. While future tax proposals undoubtedly will change the current tax landscape, second homes still will be favored when compared to other proposed restrictions on real-estate investments. You can sell your primary residence, pocket the $500,000 gain ($250,000 for single persons) and retire in your second home.

Second homes can be obtained via a stepping stone process or a one-time transaction. This is where the “just buy another property anywhere” idea can be the key to your second home. Let’s define the most important steps. You do not necessarily need all of them to accomplish your goal.

Temporary Property – Often the only piece of real estate you can afford other than your primary residence. This can be a commercial property, rental house, vacant land, or an apartment building you already own or plan to purchase. This is usually an investment property that can be sold via a 1031 Exchange to obtain a home that includes the amenities you’d like in a weekend getaway or the last home you see yourself occupying. The replacement rental home could be converted to a principal residence after it has been "aged" as an investment to insure the exchange. For example, accountants like to have two years of tax records on file showing the house as investment property before it is converted to a principal residence. Bubble Home – The home and area might be right, but you can’t say you’ll purchase and be there forever. Hence, it’s “on the bubble” to keep or sell. This is sometimes a vacation property or second home that you already own. Perhaps it is mostly a rental now that you use for family vacations one or two weeks a year. It may have been the family cabin that you inherited from your parents. It could become your ultimate home, but you are not sure at the moment if you would ever sell it. Final Destination – You are firmly convinced you will never sell this place. It may eventually be your only personal residence or it may be your second personal residence. You want to spend every day you can here and you probably will never rent it out. When you die, it goes to your estate.

By buying one property - or a series of properties - and having renters pay for it (Temporary), then selling the property via the 1031 Exchange and buying one more to your liking (Bubble or Final Destination), you defer (save) the gain on the rental property. Don’t like your new neighborhood? Sell the home while it is still a rental property and find another via another 1031 Exchange. If you already have moved in and converted it to your personal residence, sell it a few years later and move to another place. Or, borrow against the equity of your primary residence and use the loan as the down payment on a rental in a community that is your Final Destination. Rent the Final Destination home for two years then move in to it. Sell, or again rent, the previous home. When done correctly, all transactions would be tax-free.

How is that possible? Not only is it possible, but it also is rather simple and actually OK with the Internal Revenue Service. Your intention at the time of the exchange is the only relevant fact. You can immediately thereafter change your mind and convert the usage of the property. The IRS will examine the “objective manifestations of your intent” and attempt to determine what your intention truly was.

For example, let’s say Sparks Smith, a longtime electrician known for his speedy house calls, owned one rental property - a cute duplex in the inner city he bought for $50,000 that was now worth $250,000. Sparks heard the printing press around the corner – the employer of his tenants for more than a decade – was going to lay off most of its work force. Sparks, a scratch golfer, decided to exchange his $250,000 duplex for a golf course home in Florida worth $350,000 because he knew the house would bring premium rental income from Northeast snowbirds, and those rents would more than cover the $100,000 mortgage payment, taxes, and insurance of the golf course home. After renting to a Maine couple for a month, Sparks was named groundskeeper at the course. The new job justifies the change in status of the golf course property (investment to private residence), so Sparks could move in, deem it his primary residence, and not have to worry about $200,000 gain resulting from the duplex. That’s because the IRS probably would approve the conversion of golf course rental to residence because his personal circumstances changed (new job) and he wanted to move into the property.

Remember, your intention at the time of the transaction is the only relevant fact. You can immediately thereafter change your mind and convert the usage of the property. The IRS will examine the “objective manifestations of your intent” to determine what your intention truly was. (We will detail that process, plus examine other options, in Report # 4 - Tax Reform Multiplied Second Home Possibilities Coupling Dreams with Tax-Deferred Exchanges”). However, if Sparks had the intention from the start of converting the golf course property to a personal residence as soon as is was safe to do so, his entire transaction could be taxable. That was not the case – Sparks Smith’s initial intention was to save the rental income brought by the snowbirds. Had he not accepted the new job, and the rental income was not as big as expected, he still could change his mind and convert the property into a personal residence. Sparks should be prepared to prove that his intention had changed, perhaps by showing his rental income had not reached the volume anticipated.

New tax timeline for exchange property residents.

Deep in the folds of the recently signed American Jobs Creation Act of 2004 - the same law that will allow residents of the seven states that don't levy a state income tax to deduct sales taxes from their federal income tax in 2004 and 2005 – is a subtle yet important change for homeowners who have acquired their principal residence via a tax-deferred exchange.

The new law, signed by President Bush while flying on Air Force One to a campaign appearance in Pennsylvania on October 22, 2004, includes a stipulation that the exchange property must be held for five years in order to qualify for the $500,000 ($250,000 for a single person) principal residence tax-free exemption.

“It may be disguised as a safe harbor for people who buy an investment property, rent it out for three years, then live in it for two years before selling it,’’ said Kelly Yates, attorney and exchange specialist for Exchange Facilitator Corp. “Yet it appears that they are trying to clamp down on people who simply buy investment properties and then move into them.’’

In order to qualify for the $500,000 exclusion ($250,000 for single persons), homeowners must have owned and used the property as a principal residence for two out of five years prior to the date of sale. Second, the owner must not have used this same exclusion in the two-year period prior to the sale. So, the only limit on the number of times a taxpayer can claim this exclusion is once in any two-year period.

The committee that drafted the section of the new law did not believe the principal residence exclusion “was appropriate for properties that were recently acquired in like-kind exchanges.” Under the exchange rules, commonly known as 1031 Exchanges or Starker Exchanges, a taxpayer that exchanges property that was held for productive use or investment for “like-kind” property may acquire the replacement property on a tax-free basis. Because the replacement property generally has a low carry-over tax basis, the taxpayer will have taxable gain upon the sale of the replacement property.
However, when the homeowner converts the replacement property into a principal residence, the taxpayer may shelter some or all of this gain from income taxation. The committee believed that this proposal “balances the concerns associated with these provisions to reduce this tax shelter concern without unduly limiting the exclusion on sales or exchanges of principal residences.’’

While the new “Five-Year Rule” is important – especially to folks looking to move into a rental property that they have owned – it is not critical. That’s because an investment property typically needs to be rented (used as an investment) after an exchange to show the exchange was clearly an investment-for-investment transaction. Accountants say the exchanged property should be held for at least two years as an investment property before an owner considers converting it to a primary residence. In addition, once the homeowners move in to the new primary residence, they must stay at least two years before qualifying for the $500,000 exclusion.

When you add the suggested two years as investment property with the two years required under the residency guideline, that’s four years minimum needed for the new mandatory Five-Year Rule.

For those who leave their home because of a disability, a special rule makes it easier to meet the two-year requirement – especially if you were hospitalized or had to spend a significant period in a similar facility. In such cases, if you owned and used the home as a principal residence for at least one of the five years preceding the sale, then you are treated as having used it as your principal residence while you are in a facility that is licensed to care for people in your condition. This rule, especially helpful for some seniors, enables the family to sell the home to raise cash for the expenses without incurring a large tax bite.

Yates and other tax attorneys caution that all exchanges must meet the “facts and circumstances” test regardless of how much time has passed before converting an investment property to a personal residence. If it’s clear at the time of the exchange that a taxpayer intended to use the exchange property as a primary residence, the exchange can be attacked, Yates said.

A tax-deferred exchange proceeds just as a “sale” for you, your real estate agent, and parties associated with the deal. In fact, Richard Morse, attorney at Washington Exchange Services, refers to exchanges as “legally sanctioned fiction.” Section 1031 of the Internal Revenue Service code specifically requires that an exchange take place. That means that one property must be exchanged for another property, rather than sold for cash.

The exchange is what distinguishes a Section 1031 tax deferred transaction from a sale and purchase. The exchange is created by using an intermediary (or exchange facilitator) and the required exchange documentation.

If you’ve traded for a golf course getaway condo and now think you would like to live there, make sure you own it for five years before attempting to pocket a principal residence exemption.

However, once you get there, do you think you’ll ever want to sell?

Copyright Inman News. Used with permission.

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