Case Study: Nontaxable Exchanges; Passive Activity Rules

Facts: Gerald and Lisa are a married couple who decide to relocate from New York, where they have lived in their home for 15 years, to Connecticut, where they have a vacation home. They sell the New York home, which has a basis of $500,000, for $1.2 million.

Instead of moving into the vacation home, they choose to sell the vacation home, which has a basis of $250,000, to their daughter, Michelle, for $300,000. Michelle, who is a real estate agent, assumes Gerald and Lisa's $100,000 mortgage on the vacation home, which she also plans to use as a vacation home in the future. Michelle plans to cover the cost of the mortgage by renting the property for a portion of the year.

Gerald and Lisa purchase a new home in Connecticut for $1 million and decide to use that residence as their home. However, after putting about $150,000 in renovations into the home, six months later Gerald receives an unexpectedly large bonus from work and they decide to sell the Connecticut home for $1.4 million.

1) What are the related party rules and how might they apply in Gerald and Lisa's situation?

2) Will Gerald and Lisa recognize any gain? Why or why not?

3) How do the like-kind exchange rules apply to exchanges of real estate?

3) Are Gerald and Lisa entitled to use the rules that allow taxpayers to avoid recognizing gain on the sale of a residence in some circumstances?

4) How might the passive activity rules impact the tax treatment of amounts Michelle receives from renting her vacation home?