Q: I am selling a cabin which I have owned and used as a vacation home since 1994. I am using the proceeds of the sale to pay for the new vacation home which I recently purchased.

I am concerned about the amount I will have to pay in capital gains. Would I benefit by selling the property on a contract for deed, requiring a nominal down payment and monthly payments sufficient to cover my new mortgage payments?

The cabin initially cost $30,000 and I am selling for $160,000. I purchased the new property for $188,500 and have an ARM at 6.125% with a three year balloon.

A: I wish you had written me before you closed on the purchase of the replacement vacation property. You may have been able to defer all of the capital gains tax you might have owed.

What you should have done is set up a 1031 tax free exchange, also known as a Starker Trust, of your vacation homes, which are investment properties.

The 1031 tax-free exchange allows you to sell your current investment property and purchase another one and defer all capital gains tax. There are some strict guidelines you must follow for a correct exchange, including the property must cost at least the same or more than the property you are selling and you must close on the purchase of the replacement investment property within 180 days of selling your current vacation home. There are other rules you must follow, including having a 3rd party hold the funds.

Although you have already begun the process of selling and buying, it may not be too late to set up the 1031 tax free exchange. Call your local bar association for a referral to a real estate attorney who handles tax-free exchanges regularly.

If you fail to set up the tax-free exchange ahead of time, or if you miss one of the deadlines, you cannot go back and redo it. If you decide not to set up the exchange, you will have to pay the recapture on any portion of the vacation home you have written off over the years plus a maximum of 15 percent on your profit.

For more details, consult with your accountant or tax preparer.

Published: Aug 13, 2004