Q: I have a summer cottage that I have had about 25 years and always rented it until 2 years ago when I used it during the summer for myself.

I know if I sold it there would be big capital gains. I paid about $42,000 for the property and I might be able to sell it for $225,000.

If I sold it and bought another cottage/house for $250,000 and sold that in 2 years for 275,000 would the capital gains be less?

A: You’ve owned a piece of real estate for 25 years and rented it for most of that time. If you took advantage of the provisions of the tax code and treated the property as an investment property, for federal income tax purposes you probably took advantage and depreciated the cottage over those years. That depreciation gave you tax advantages over time, but now your tax basis for the cottage is close to zero.

That is to say, for income tax purposes, the IRS will treat the cottage as having little value and when you sell it you’ll have to pay taxes on the appreciation on its value. In addition you’ll have to pay taxes to repay the IRS for the tax benefits you received over the years for the depreciation you have taken.

If the cottage is still considered investment property by you and your use over the past two years has not converted the cottage from an investment use to a personal use, you can sell the cottage and defer paying any taxes on the sale of the cottage by using a 1031 tax deferred exchange at the time you close.

You would close, but rather than getting any money at the closing, you deposit all the proceeds with a company that acts as an intermediary until you can find a replacement property.

There are many companies that act as a 1031 intermediary, but you need to make sure the company has been around for some time and actually have a mechanism in place to secure the funds they hold on your behalf and have a mechanism to protect those funds in case the company goes out of business.

Once you have closed, the 1031 exchange mechanism allows you 45 days to find and designate a replacement property and, in most cases, 180 days to close on the purchase of the replacement property. When you close on your replacement property, you will then use the funds from held by the 1031 intermediary company and you have deferred having to pay any taxes on the sale of the cottage.

November 20, 2007