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How To Buy a Vacation Property with a 1031 Exchange

Wouldn’t it be wonderful to have a beautiful vacation home? My clients ask me all the time if they can use a 1031 exchange to accomplish this very thing. It is possible but getting to the finish line can be a bit tricky which is why it is important to use a real estate agent that specializes in 1031 exchanges.  Let me give you an example.

You can sell your primary residence and shield $500,000 in capital gain, so long as you’ve lived there for two years out of the past five. But this break isn’t available for your second or vacation home, unfortunately. There are stories all over the place about of taxpayers who were able to use a 1031 to swap one vacation home for another, perhaps even for a house where they would retire. The 1031 would delay any recognition of gain. Later you would be able to move into the new property, made it your primary residence and eventually plan to use your $500,000 capital gain exclusion.

In 2004, Congress tightened that loophole but you are still able to turn vacation homes into rental properties and do 1031 exchanges. For example, you stop using your house, rent it out for a year and then exchange it for other real estate. If you get a tenant and rent it out the home, and converted the house to investment property, it should make your 1031 exchange OK. If you try and be sneaky and hold it for rent without ever having a tenant, that would be not OK. It really just all comes down to timing. The more time that you allow to pass after you convert the property’s use the better it looks.

If you want to use the property you swapped for as your new second or even primary home, you can’t move in right away. In 2008 the IRS set forth a safe harbor rule under which it said it would not challenge whether a replacement dwelling qualified as investment property for purposes of a 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange. First, you must rent the dwelling unit to another person for a fair rental for 14 days or more; and second your own personal use of the dwelling unit cannot be more than the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

To expand even further, after successfully swapping one vacation/investment property for another, you can’t immediately convert it to your primary home and take advantage of the $500,000 exclusion. Before the law was changed in 2004 an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period of time, move into the property for a few years and then sell it, taking advantage of exclusion of gain from the sale of a principal residence. Now, if you acquire property in the 1031 exchange and later attempt to sell that property as your primary residence, the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange. To sum it up, you’ll have to wait a lot longer to use the primary residence capital gains tax break.


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5 Things to Know About 1031 Exchange

Before jumping into a 1031 exchange, there are some important things you should know that might save you a lot of headache down the road.

Any cash you receive will be taxed.
Once you have purchased an investment property, any cash you have remaining from the sold property can and will be taxed as a capital gain. Take this into account when deciding how much you want to put towards another property.

Broad terms can be dangerous.
A 1031 exchange only requires that the next property be “like-kind” which could mean any number of things and can be very misleading. With a 1031 you can exchange a land lot for a condo, or an industrial building for a strip mall. Be warned though, you can get yourself into tax trouble if the 1031 exchange is not true like for like exchange.

You must consider mortgages and other debt.
To protect yourself, you need to take a look at any loans or other debts on the property you are planning on letting go of and look at the cost of the property you are replacing it with.  Think of it this way… if the property you were going to sell had a $1 million mortgage but your new property is being purchased for $900,000. You will have $100,000 of capital gains and it will be taxed heavily.

Your next property must be selected.
If you decide to delay your 1031 exchange, there are two rules that you must take into consideration. Once you sell your initial property, a third party will receive the funds. If you receive the cash, it will end the 1031 exchange.  The first rule states that replacement property options must be identified within 45 days of closing on the subject property. The second rule states that within 6 months of the sale, you must subsequently have completed the purchase of the replacement property.  You must keep the 1031 facilitator in the loop with your activities during the transactions.

Using a 1031 exchange for personal use is a big No No.
A 1031 exchange is only for investment and business property, so you can’t swap your primary residence for another home. There are ways you can use a 1031 for swapping vacation homes, but this loophole is much narrower than it used to be. It’s also good to note that that exchanges of corporate stock or partnership interests don’t qualify but interests as a tenant in common in real estate do.



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Common Mistakes Home Buyers Make

Common Mistakes Buyers Make When Purchasing A Home

To understand the home buying process and the current market you are currently shopping in is crucial to successfully purchase a home. You should be vigilant and avoid these common mistakes so you don’t miss out the home of your dreams!
Not knowing your numbers before you look at a house:
You should always get preapproved before beginning your home search. A good lender will provide you with an estimate to give you a better sense of what you can afford. A $600,000 home sounds excellent, but what does that mean for a monthly mortgage payment? Does it line up with your budget? Do you know how much your closing costs will be? By knowing this information ahead of time, you can figure out what works and then work it backward. Knowing what you can afford in the beginning will make for a better negotiation and experience. If you don’t have a lender, your real estate agent will be able to recommend someone they personally use and trust.

Writing an offer based on someone else’s:
What does a great deal mean to you? Many home buyers assume that they can get the same deal that another friend or a family member received. More times than not they only have half the story, they are in a different market or their financial situation is very different from yours. Work with your agent and write the deal that will get you into your perfect home.

Waiting too long to write an offer based on what others think:
Buying a home will be one of the biggest financial decision of your life and having people close to you to help with the decision making can be helpful or it can hurt. I’ve seen both. Be sure to sit down with your agent and discuss your specific needs and goals when it comes to a new home. Also, beware of bringing family and friends to showings. The homes you see should match the conversations that you have had with your agent. Everyone has an opinion and the very things you love in a home will probably not be the same for your friends and family. Do not let that discourage you from pursuing a home.
These are just to name a few mistakes home buyers can make when buying a home.
Want to see what a good buyers agent can do for you?  Check out this video!
Call us today and let us help you avoid some of the common mistakes buyers make when purchasing a home.