As popular as tax-free exchanges have become to investors and second-home buyers, facilitators are still facing the basic questions that were asked two decades ago.

The Federation of Exchange Accommodators (FEA) is a national trade organization formed in 1989 to represent qualified intermediaries (QIs) and their primary legal and tax advisors who are directly involved in Section 1031 exchanges, sometimes known as Starker exchanges. At the recent FEA mid-year conference in Washington, D.C., attendees shared common challenges they faced regarding the 1031 exchange industry. Vacation homes topped the list, even though the Internal Revenue Code is clear on the rules that differentiate a vacation or second home from investment property.

“Some business magazines and some Web sites have been giving information to consumers that is not correct,” said Tom Oldfield, a Tacoma, Wash., attorney and partner in Olympic Exchange Accommodators who attended the D.C. conference. “It seems many taxpayers believe they can exchange a vacation home at any time and that’s just not the case.”

Section 1031 of the IRS code allows that a property held either for business or investment can be exchanged tax-free for another “like kind” property of equal or great value if the exchange adheres to specific guidelines.

So, is your vacation home an investment property that can be exchanged or a second residence that would face a tax liability if it is sold? It usually comes down to how many personal days you use the property for vacation. If your vacation home is an investment property, the rule is that personal days must not exceed the greater of 14 days or 10 percent of rental days.

“Some people rent out their vacation home some years and don’t have any personal use,” Oldfield said. “Others rarely rent it out and use it solely for their family and friends. If you want to use the vacation home in a tax-deferred exchange, it must be used as a rental at least for the entire previous year and rented out at fair market value.”

Homeowners can flip-flop the status of the vacation home each year. For example, let’s say the cabin was used as a second residence in 2006 when you didn’t rent it out at all and it was used only for family weekends and reunions. However, in 2007 a college professor from the nearby community college rented the place for three academic quarters and the cabin became an investment property, thereby changing the tax status.

If you are planning to execute a 1031 tax-free exchange, make sure your vacation home held investment status for at least the previous year before attempting an exchange. While there are no absolute rules as to how long the property should be held as an investment, accountants suggest that the property show up as a rental on at least two consecutive tax returns.

“The consecutive part is what has been missing in some newspaper and magazine reports,” Oldfield said. “Some taxpayers have been led to believe that once the cabin has been used as an investment property that it can be used in an exchange at any time. If it reverts back to a second home in the year before the exchange, it would no longer be investment property and thus not eligible for the exchange.”

Income derived from renting out a second home or primary residence for a term of 14 days or fewer does not have to be reported to the IRS and does not change the tax status of the home. It’s only when you exceed the 14-day limit that a change occurs. The short-term rental (fewer than 14 days) happens all the time at pro golf tournaments where players or officials rent out fairway homes for the week or 10 days surrounding a big tournament. It’s a great way for homeowners to pocket tax-free cash.

Another popular tax strategy, especially for retirees, is to convert the second home to a primary residence. For example, let’s say a couple retires and sells the longtime family home, pocketing $500,000 tax-free from its sale. The couple moves into their vacation home, making it their primary residence. Two years later, they can sell the place, move into an in-city apartment and pocket up $500,000 tax-free again because it had become their primary residence.

Vacation homes can definitely help with your financial picture, however, make sure you are clear on the status before you attempt to trade or sell.

To get even more valuable advice from Tom, visit his Second Home Center.

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