Does a Vacation Home Qualify
For a 1031 Exchange?

Question: I have been told that vacation homes qualify for a 1031 exchange. Is that true? I have never rented my Maryland beach house, but I also have only occupied it during the summer months. It is otherwise empty. I have owned it for more than 20 years, and needless to say the tax bite would be substantial if I decided to sell. That's why exchanging interests me.

-- MA, Ocean City.

Answer: Exchanging properties in and of itself is rather complicated. But exchanging a vacation home may be possible.

For the uninitiated, Section 1031 of the Internal Revenue Code allows investors to sell a property, reinvest the proceeds in a new property and avoid all capital-gains taxes. The regulation states "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."

The term "like-kind" is often thought to mean that one type of property must be traded for the exact same property type, but that is incorrect. Any real property held for investment or used in a trade of business can be swapped for any other property held for investment or used in a trade or business.

But the properties don't have to be traded directly. Rather, in a 1031 exchange, you can sell a property to one person and buy another property from another person as long as both transactions occur within a specific time period and meet a bunch of other rules.

For example, for an exchange to be structured properly, all proceeds must be reinvested. If not, the difference is considered "boot" that must be recognized as a taxable gain. That is, if you sell a property for $2 million and buy another for $1 million, you'll have a $1 million taxable gain.

Also, if the property being sold is financed, the replacement property must be acquired with an equal or greater amount of debt. If not, the exchanger is relieved of a debt obligation, which is considered "mortgage boot" and is a taxable gain unless it is offset by an equivalent cash investment in the replacement property.

And theses are just the basics, which is why it's imperative to first consult with your tax or legal advisor and then find a "qualified intermediary" to handle the details.

For the answer to your specific question regarding vacation homes, I turned to Michael Brady, eastern region vice president of Asset Preservation Inc. in Calverton, N.Y. API (www.apiexchange.com) is a leading qualified intermediary that has successfully completed more than 120,000 Section 1031 tax-deferred exchanges.

Normally, residential property that is not rented and does not otherwise produce income does not qualify as "investment property." But many investors exchange out of true investment properties -- a single-family rental, for example -- and into a vacation or second home. And Brady says many tax and legal advisers believe it is possible to exchange out of a vacation property which has no rental history as long as the exchanger can demonstrate it was held for investment.

They base their opinions on a Private Letter Ruling (PLR 8103117) by the IRS that allowed for tax deferral when the exchanger intended to acquire property for personal enjoyment and as an investment. However, a ruling such as this applies only to the facts and circumstances in a particular situation.

"There are no regulations, statutes or court cases which give a definitive answer to the question of exchanging vacation or second homes," says Brady. "Each exchange must be reviewed on a case-by-case basis. But in this particular case, the 'personal enjoyment' of a property did not prevent the owner from benefiting from a tax deferred change."

Intermediaries such as API are not allowed to provide legal or tax advice, so you should choose carefully. But Brady does point out that IRS regulation 1.1031 (b) states that "unproductive real estate held by one other than a dealer for future use or future realization of the increment value is held for investment and not primarily for sale."

Consequently, he says, "it appears that even property owners who have never rented their vacation property but can substantiate that they acquired and held the property because they expected it to increase in value may qualify for a Section 1031 tax deferred exchange."

Armed with this information, your next step is to consult with your tax and legal advisers.

And one more thing: I asked Brady how you might be able to show you were holding the property for investment. He suggested that renting it to unrelated parties for one or two years prior to the exchange should do the trick. But if you go this route, use a written lease and report your rent as income and expenses as deductions on your annual tax returns. Also limit your personal usage.

Additional methods you might use to support your position include documenting that you investigated appreciation rates, capitalization rates and possibly even rates of return prior to purchasing the property; keeping logs of repair and maintenance expenses during the period of ownership and having the property appraised periodically to keep track of its value. Any rental, even to family or friends, also will help establish the property is being held for investment.

Question: I am hoping you can point me in the right direction in finding a mentor to learn the ins and outs of flipping properties. I am a health-care professional looking to start an additional business. I have come across these so called "gurus" and I'm not willing to invest a dime in anyone of them. I would appreciate some direction.

-- Dr. Ed.

Answer: Flipping is an easy-entry, easy-failure business, especially for someone who doesn't have the ability -- or the time -- to make a lot of his own repairs and improvements. The trick is to get in cheap, fix up a place cosmetically and get out fast at a higher price. If you have to pay a contractor to do the fixing, you must achieve an even higher price to make the same profit. And if you pick a contractor who's not terribly reliable, you're holding period will be that much longer.

I'm not sure this is the right time to get into the home rehab game, anyway, largely because the housing market in most places seems to be on the downside of a cyclical curve. In other words, values are no longer escalating at nearly the same rate they have over the last four or five years, if they are escalating at all. So it will be even tougher to make a buck, especially if other owners in your neighborhood decide to cut their asking prices in order to sell.

That said, I agree with your decision not to spend a dime with the real estate gurus. I wouldn't even spend a nickel. Rather, I'd take advantage of the current pause in the market to head down to my local library and look for books on the topic. There are dozens of them, and each contains a nugget or two that you can use. Better yet, unless you don't return the books on time, they're absolutely free.

Incidentally, newsletter/book writer and investor John Reed has a section on his Web site (www.johntreed.com/realestate) devoted entirely to "rating" -- more like debunking -- the gurus. It is must reading for anyone thinking even remotely about making a quick kill in turning houses.

Email your comments to rjeditor@dowjones.com.