Strategic Capital Gain Tax Liability Management: A New Way Out

1031 Tax Deferred Exchange Not Always Best Option
Investors often flock to the 1031 tax deferred exchange strategy each time they are contemplating selling real estate or personal property without considering all of the available options.

And, while I am certainly biased toward the 1031 tax deferred exchange with my 24 years in the 1031 exchange industry, and the 1031 exchange is generally the best tax deferred solution available, I am also the first to admit that the 1031 tax deferred exchange strategy may not always be the best option for certain investors under certain circumstances.

The New Way Out
There may be a New Way Out; an innovative tax deferred strategy available to investors that are selling real estate, businesses or other assets that do not wish to acquire like-kind replacement property as required under the 1031 tax deferred exchange or may not be able to do so because of real estate, lending, or credit market conditions.

It can be exceptionally challenging to structure 1031 tax deferred exchange for the sale of a business or assets used in a business. Identifying suitable like-kind replacement property can be most challenging, if not down right impossible in cases like this.

Deferred Sales Trust
This new and innovative capital gain tax deferral strategy is called the Deferred Sales Trust™ and operates very similar to an installment sales contract under Section 453 of the Internal Revenue Code.

The Deferred Sales Trust permits the investor to sell real or personal property, especially a business, and defer the payment over the term of the installment sale contact or seller carry back note. The Deferred Sales Trust can be an exceptional estate planning tool and even a rescue vehicle for a failed 1031 tax deferred exchange.

Does My Vacation Property Qualify for 1031 Exchange Treatment?

I can't tell you how many debates I have listened to or participated in regarding vacation homes or vacation property and whether it does or does not qualify for 1031 exchange treatment. The arguments were always the same. Would the IRS consider the property held for personal use or held for investment?

The more the vacation property or second home is held and used as investment property the better you were, and the more that you used the property for personal use the less likely it was that it would qualify for 1031 exchange treatment.

Moore vs. Commissioner
There was a court decision in Moore vs. Commissioner that held that a vacation home or vacation property must be primarily held for investment and not primarily held for personal use or enjoyment in order to qualify for 1031 exchange treatment.

Revenue Procedure 2008-16
The Internal Revenue Service issued Rev. Proc. 2008-16, which addressed this issue very well. It was in fact a very generous ruling in favor of the taxpayer. We updated our extensive article regarding the qualifications of a vacation property or second home and whether it qualifies for 1031 exchange treatment.

Safe Harbor Ruling
However, the Rev. Proc. only provides certain safe harbors. This means that if you fall within the safe harbors you will qualify for 1031 exchange treatment. But, it also means that if you fall outside of the safe harbors it does NOT mean that you do not qualify. It just means that you can not take advantage of the safe harbor provisions, but you must be extra careful when proceeding with your 1031 exchange going forward.

Strategic Thoughts
Vacation properties or second homes that fall outside of the Rev. Proc. may still qualify for 1031 exchange treatment. Taxpayers merely have to be more diligent in their planning to ensure a successful 1031 exchange.

Here are some thoughts that you may wish to consider:

• Rent out the vacation property or second home as much as possible.
• Put the vacation property or second home in a rental pool.
• Limit your personal use of the property to less than 14 days per year if at all possible.
• Don't use the property for any personal use in the year in which you will sell the property.
• Treat and report the property as investment property for income tax purposes, including depreciation (the IRS will tax you later on deprecation recapture whether you depreciated the property or not).
• Always charge fair market rental rates when you rent the vacation property or second home to your relatives and friends that use the property and make sure that you report this on your income tax return.
• The best of all solutions is to cease all personal use for at least 12 months before the sale and rent the property for 100% of that time. This way it is well documented that you are holding it for investment purposes and are collecting rent and paying taxes as investment property.

You can easily structure the sale of your vacation property or second home so that it will qualify for 1031 tax deferred exchange treatment if you follow the above suggestions and leave plenty of time to do so.

Deferred Sales Trust to the Rescue
However, for those who do not have time to properly structure the sale of your vacation property or second home for 1031 tax deferred exchange treatment, you may wish to consider the Deferred Sales Trust as a tax deferred solution on the sale of your property. Property does not have to be investment property in order to take advantage of the Deferred Sales Trust.