In many areas, vacation home prices have skyrocketed, along with property insurance costs. If you own a highly appreciated vacation property, is it time to cash out and simplify your life? You could simply sell the property and accept the tax hit on your gain. (See “Get the Timing Right” below.) Or you could explore the following three tax-saving strategies.

Option 1: Convert the Property into Your Principal Residence One possible tax-smart option is to move into your vacation home. If you live there for at least two years before selling, the property can become your principal residence, potentially qualifying it for the federal income tax home sale gain exclusion. This exclusion is one of the most significant personal tax breaks on the books. Eligible single taxpayers can exclude home sale gains up to $250,000, and eligible married joint-filing couples can exclude gains up to $500,000. Married people who file separately can qualify for two separate $250,000 exclusions. To be eligible for the home sale gain exclusion, you must pass the following two tests: Ownership test. You must have owned the property for at least two years during the five-year period ending on the sale date. Use test. You must have used the property as your principal residence for at least two years during the same five-year period. Important: To qualify for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test. Beware, however, of a little-known rule that may reduce your allowable gain exclusion. (See “Computing Nonexcludable Gains on Vacation Homes” at right.) Option 2: Leverage a Tax-Favored Section 1031 Exchange Another tax-smart strategy is to arrange a Section 1031 (like-kind) exchange. This option is available only for properties used for business or rental purposes. So, if you haven’t been renting your vacation home, you’ll first need to convert it to what qualifies as a rental property under the tax law.

When available, a Sec. 1031 exchange allows you to unload an appreciated property (the “relinquished” property) and acquire another one (the “replacement” property) without triggering a current federal income tax bill on the relinquished property’s appreciation. The gain is rolled over into the replacement property, where the gain is deferred until you sell the replacement property in a taxable transaction.

What happens if you still own the replacement property when you die? Under current federal income tax rules, the tax basis of a deceased person’s share of the property is “stepped up” to its date-of-death value. In that situation, your share of any taxable gain accrued during your lifetime would be completely washed away.

The IRS established a “safe harbor” that allows tax-deferred Sec. 1031 exchange treatment for swaps of vacation properties, including “mixed-use” vacation homes that you’ve rented out part-time and used personally part-time. To be eligible, both the relinquished and replacement properties must meet the safe-harbor requirements.

Specifically, the relinquished property must pass two tests:

• You must have owned it for at least 24 months immediately before the exchange.
• Within each of the two 12-month periods during the 24 months immediately before the exchange: 1) you must have rented out the property at market rates for at least 14 days, and 2) your personal use of the property can’t have exceeded the greater of 14 days or 10% of the days the property was rented out at market rates.

In addition, the replacement property, which can be virtually any kind of real estate, must pass two tests:

• You must continue to own it for at least 24 months after the exchange, and you must hold it for rental or business purposes.
• If the replacement property is another vacation home, within each of the two 12-month periods during the 24 months immediately after the exchange:
  1. You must rent out the property at market rates for at least 14 days, and
  2. Your personal use of the property can’t exceed the greater of 14 days or 10% of the days the property is rented out at market rates.

Executing this strategy is complicated. Consult your Isdaner tax advisor for the details.

Option 3: Hold the Property

Sometimes, doing nothing might be the best move. Holding on to your vacation property until you pass away could be a tax-smart choice because of the step-up in basis rule. When you die, the tax basis of your share of the property is adjusted to its fair market value at the time of your death, eliminating your share of any taxable gain that accrued during your lifetime.

If your heirs subsequently sell the property, they’ll be taxed only on any post-death appreciation. However, if you and your spouse co-own the property, the basis step-up rule can be tricky. Consult your Isdaner tax advisor for full details on how it works in that scenario.

It’s Not All About Taxes

While taxes are important, they shouldn’t be the only factor in your decision. Vacation homes often carry strong emotional significance. The right strategy depends on various factors such as:

• Your age and health,
• Family members’ emotional ties to the property, and
• Your financial situation and long-term goals.

For instance, the considerations for a retired couple may differ from those of a young couple with busy young kids. Consult your Isdaner tax, financial and legal advisors to discuss what’s right for your situation.