By Todd Smith, MBA, Haas School of Business

One of the investment advantages of owning real estate is that an investor can defer paying taxes on the profitable sale of a property. Savvy investors use a deferred exchange, or 1031 exchange, to avoid paying capital gains taxes.

Although this system has helped investors build equity for different kinds of investment properties, Helium Report has found that it is challenging to use this tax advantage for fractional vacation properties, such as private residence clubs.

How does a 1031 exchange work?

You can defer taxes on your investment real estate gain if you roll your sale proceeds into a property of equal or greater value. When you are relinquishing your current property, you must identify the property to be purchased (the replacement property) within 45 days following the sale of the relinquished property.

The exchanger must obtain the replacement property within 180 days following the sale of the relinquished property. Also, the replacement property must be like-kind to the relinquished property. This simply means you are exchanging real estate for some other real estate, and not some other personal property or investment. In general, any type of real estate property is like-kind to other real estate property.

Fractional Real Estate

The IRS has stated that fractional ownership in real estate does qualify for a 1031 exchange (Revenue Procedure 2002-22). It is referred to as Tenant in Common or TIC. TIC ownership allows for multiple parties to own an investment property, with each fractional owner holding a separate title to their portion of the property.

However, both the property sold and the property purchased must be held for investment or productive use. The properties exchanged cannot be for personal use. This last point is what makes it difficult to take advantage of the 1031 exchange for a vacation timeshare. If you use your timeshare as a vacation home, it will not qualify for the 1031 exchange. You would need to rent it out to others, but this would most likely defeat the purpose of owning and enjoying the timeshare for yourself.

International Properties

What about 1031 exchanges for properties in foreign countries? The IRS code states that real estate outside the US cannot be exchanged for real estate inside the US because the properties are not “like kind.” This is because once the gain is deferred into a foreign property the IRS loses track of it. However, you can take advantage of the 1031 exchange if you are selling in one foreign country and buying in another.

Keep in mind you should work with a professional if you are engaging in a 1031 exchange. There are many companies that specialize in these transactions and will help you for a reasonable price.

Learn more about private residence clubs and access Helium Report’s comprehensive directory of more than 200 luxury options.