QUESTION: How does the Internal Revenue Service treat the capital gain or loss on a second home? I have a second home that I plan to sell. May I purchase another house as my second home and apply the gain from the sale to it to defer taxation on the gain? --N. R.
ANSWER: No. The sale of a second home is not treated the same as the sale of a primary residence, and you may not simply defer taxation on your gain by purchasing another vacation house of equal or greater value. However, if your second home is a piece of investment property that generates rental income or is specifically held to realize appreciation, it can--and this is an all-important word--qualify for a tax-deferred exchange upon sale.
When is a second house an investment and not a vacation retreat? Well, if you bought the property solely with the intent of letting it appreciate in value and used it sparingly as a vacation retreat, your claim would probably withstand scrutiny from the IRS, our experts say. The IRS requires that personal use be no more than 14 days a year, or 10% of the time if the house is rented. So, if you don't rent the second home at all, you may use it up to 14 days annually and retain its investment property status.
However, if you have deducted mortgage interest on your second home as "personal mortgage interest," as is allowed by law, you have little chance of passing it off as an investment. (But if you deducted mortgage interest payments as investment interest to the extent allowed, your claim that the property is an investment would be strengthened.)
The law outlining the requirements for tax-deferred exchanges of investment property is contained in Section 1031 of the Internal Revenue Code, which is why these transactions are sometimes referred to as "1031 exchanges." Under current law, a seller has 45 days after closing on the sale of his initial property to identify the real estate he wishes to acquire through a tax-deferred exchange. He must complete the acquisition of that property within 180 days of the closing of the first sale.
Because of the strict regulations surrounding tax-deferred exchanges, you should get help from a qualified third-party "accommodator" before attempting one of these transactions. Your real estate broker, escrow officer or family attorney should be able to steer you to an independent professional who has been trained to act as an accommodator. For additional information, see Internal Revenue Service publications No. 17, "Your Federal Income Tax," or No. 544, "Sales and Other Dispositions of Property."
One additional note: Current law permits tax-deferred exchanges among a broad variety of investment properties. For example, you may now exchange an apartment house for a shopping center, or a piece of vacant land for an office building. However, a bill pending in Congress would limit exchanges to properties of similar use: office building for office building or shopping center for shopping center, for example. Under current versions of this proposed legislation, the restriction would be retroactive to July 11, 1989. But there is no reason to panic. These provisions are included in the same legislation with the proposed new capital gains tax, and, as you well know, the outcome of that bill is still very much uncertain.
Income Averaging and Pension Money
Q: In February, 1986, I quit my job and took a lump sum distribution of my pension account. At that time, I rolled it over into a four-year individual retirement account. This account is now about to mature and I would like to take the principal, which was the lump sum pension distribution, and treat it to 10-year averaging on my income taxes. I know I meet the age qualification to take advantage of the averaging, so may I do it? --P. W.
A: It depends. By depositing your pension distribution in an IRA account, you basically lost your right to take advantage of the 10-year income averaging allowed pension distributions. However, our experts say there may be a way around your problem.
First, we have to find out if your IRA is "pure"--that is, it doesn't contain any funds other than your pension distribution and the interest earned on that amount. If it is pure, then you could roll the account back into a qualified pension plan, take a distribution from it and then take advantage of the 10-year income averaging.
If you are still employed, find out if you can make a contribution to your personal account in the pension fund your company operates. Or, if you want, you could start a consulting business, open a Keogh account and transfer your pension funds into it. The bottom line is that your funds must be withdrawn from a qualified pension plan in order to take advantage of the income averaging.