Leavenworth Vacation Homes and 1031 Exchanges

This article about using your vacation home or Leavenworth condo in 1031 tax exchange was provided by Ann Mclaren of LandAmerica 1031 Exchange Services. I have been fortunate to take a 1031 class from Ann in the past and I welcome anyone to contact her directly for more details on 1031 exchanges. She can be reached at (866) 962-1031. I hope to have more articles from her in the future.

A vacation home or second home held for personal use, solely for personal enjoyment, is not eligible for 1031 exchange treatment. However, a vacation home that is rented out at fair market value and is never used by the owner or his family is clearly eligible for 1031 exchange treatment. Most vacation properties fall somewhere between these two extremes, with some personal use and some rental use. Until recently, there has little binding guidance on the exchange of vacation properties in 1031 exchanges.

Revenue Procedure 2008-16, which is effective on exchanges occurring on or after March 10, 2008, provides safe harbor rules for vacation homes and properties converted to or from personal residences. If the safe harbor guidelines are met, the IRS will not challenge whether the property qualifies as property held for productive use in a trade business or for investment under Section 1031.

A vacation home or second home that you are selling and/or purchasing in a 1031 exchange will qualify for safe harbor tax-deferred treatment if:

1) The relinquished property is owned by you for at least 24 months immediately before the exchange and the replacement property is held by you for at least 24 month immediately after the exchange.

2) The dwelling unit is rented out at fair market value to another person for 14 days or more for each of the two years immediately before the exchange for relinquished property or two years immediately after the exchange for replacement property.

3) Your personal use is limited to the greater of 14 days per year, or 10 percent of the number of days of the year that the property is rented at fair market value, for two years prior to or after the exchange. You may use the property some additional days for repairs and annual maintenance, but must be prepared to prove actual work done.

Personal use is defined as being used by you, any family member, or anyone who has an interest in your property, such as a tenant in common, or by any arrangement where fair market rent is not paid. You may rent your property to a family member if they use it as a principal residence (not as a vacation home) and pay fair market rent.

Under these safe harbor guidelines you may sell, exchange, or move into your replacement property after you have met the requirements for the first 24 months. 1031 exchanges of vacation properties or second homes that do not follow the safe harbor guidelines in Revenue Procedure 2008-16 may still qualify for 1031 exchange treatment outside of these parameters, but you should be prepared for increased scrutiny by the IRS.

Author:

Ann Mclaren, Vice President

LandAmerica 1031 Exchange Services

(866) 962-1031

Leavenworth WA real estate - Should you be investing?

Are you curious about investing in the Leavenworth or Lake Wenatchee real estate market? Seems like everyone is interested in real estate investments these days. I see or hear about three types of “investors” most often in our local market. I use the quotes because most of these are “would be” investors who can’t find what they are looking for in the Leavenworth or Lake Wenatchee real estate market. (I read this article from Broker Agent News, (Top 7 Tips,) after I started my post. Notice the similarities including the use of quotes around “investor”.)

The first is the fix it and flip it investor.

Most don’t have the skills needed to fix the houses with real potential. There aren’t many homes in our market that just need a little paint and new flooring. Much of what is available needs some real love and perhaps even moving a wall or two. Another problem is the high price to get into the market. While $250,000 doesn’t seem high in Seattle or San Francisco, it seems high to a Leavenworth or Wenatchee resident for a house that needs a lot of work. Finally there is the turnaround time. Our time on market, even for great homes, can be a little tough on investors looking to get their money back. If you expect it to sell in a few weeks after you have fixed it up, you may be in for a surprise.

Second, we have the typical landlord investor.

These folks are looking for a property, especially multi-family properties such as duplexes or tri-plexes that have good cash flow. This means that the income coming in from rent is greater than the expenses for management, upkeep, and the mortgage payments. The houses are paying for themselves and the investor only needed to have enough for the down payment. Here’s the bad news- it ain’t gonna pencil. A few years ago you might have found rental properties in Wenatchee (but not Leavenworth) that had good cash flow. Not today. Why? Because real estate prices have gone up, but rental rates really haven’t. Robert Kyosaki, the author of the Rich Dad, Poor Dad series had a good idea. Write rental agreements with language that automatically raises rents yearly. How many times have I heard from landlords that they know their rents could be higher, but they didn’t want to lose their great tenants by raising the rent. Guess what? The investor buyer doesn’t care so much about the quality of the renter as much as the quality of the rent.

Third, we have the vacation home buyer.

This person wants to buy a vacation home and rent it out when it is not in use. This isn’t a bad strategy except for the following caveats.

1. Make sure the zoning allows it. In Leavenworth, “nightly/weekly” rentals are only allowed in areas with Commercial Zoning. For the most part, this means a condo, although some older houses are located in commercial areas. In unincorporated Chelan County the zoning isn’t as big of a problem.
2. Be prepared for Management Fees and Condo Association Fees. Managers for vacation rentals locally are charging 40-60% of the rental rate. Some will even charge you a cleaning fee to use your own property. Additionally the monthly condo fees can be a few hundred dollars. These fees make Cash Flow a difficult proposition.
3. When are you likely to use the property? If it’s just an investment- great. Most folks hope to come over for a few long weekends and holidays. Christmas, New Years, Spring Break, MLK Day, Oktoberfest – these are the big money makers for vacation rentals. The quiet times? Mid week (Tuesday through Thursday) and the in between seasons. Can’t golf or go skiing because the weather won’t cooperate? This is the quiet season. There is a great article about making money from vacation rentals here.

What is my advice for the real estate investor? First of all look to the long term. There aren’t many get rich quick deals. If they exist, they require lots of money and certainly talent. There is however lots of money to be made by investors who can wait a year or two. Second. Look beyond cash flow. What about the other sources of profit? Depreciation, mortgage deduction and market appreciation. One of my favorite ideas currently is land that doesn’t quite cash flow. Find a house, often a manufactured home, on a great lot that has lots of value. Rent out the house for a few years with minimal improvements. Does the renter pay the mortgage? Of course not, but when’s the last time you got rent on bare ground? In two or three years the lot has increased 20% a year and you can remove the structure and sell the ground. Similar to this is Rent, Fix and Flip. Buy a fixer upper with potential. Rent it out before you fix it and after a few years of building equity then flip it. We have great appreciation right now, take advantage of it by holding on to it. I think land is a great place to invest right now. Not necessarily large subdivisions, but little short plats of 2 to 4 lots or just keeping a small in town lot or a lot in an existing subdivision.