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Question: We own our principal residence which is located in the District of Columbia, and we also have a second home in Delaware by the ocean. I know that when we sell our principal residence, since we are married and have lived in house for many years, we are eligible for the up-to $500,000 exclusion of gain. I know that we can also deduct our mortgage interest and our real estate taxes when we file our annual income tax return. However, we do not know how to handle this for the vacation home. Can you give us some guidance?

Answer: It really depends on how you use your second home. Did you use it entirely for your personal use, or was is treated as an investment property for real estate tax purposes. For this column, I will assume that it is an investment, and that you have been renting for several years.

If, for example, you bought the home many years ago for $70,000, and added $30,000 worth of improvements, your basis in the property (excluding closing costs) would be $100,000. If you were to sell it for $200,000, your gain would be $100,000, less any real estate commissions or other expenses relating to the sale. Under current capital gains rules, you would probably have to pay 15% of this net profit to the IRS.

You do have a number of options available, however, and this column will address some of these. However, you are strongly urged to consult your own legal and tax advisors, before making any major decisions.

First, you could decide to keep the second home and continue to rent it out. If you believe there is a strong rental market, and that the house will continue to appreciate, why sell it and pay the tax? Perhaps while it is still your second home you can refinance, lowering your interest rate, so that your cash flow would not be too great. Obviously, this makes you a landlord, and unless you turn the property over to a property manager, you will have to endure the negative aspects of being a landlord as well as the positive.

Second, if you have children, leave it to them on your death, They will get what is known as a "stepped-up" basis in the property. In other words, even though your basis may be $100,000, if the value of the property on the date of your death is $200,000, the children's basis is the value on the date of your death.

Third, you might consider doing a like-kind exchange of the property. Under Section 1031 of the Internal Revenue Code, you can "swap" the beach property for any other like-kind property, and like-kind has been broadly defined to include any form of real property. It can be a farm in Ohio, an office building in New York City, or another beachfront lot or house in Florida.

This is a complex and tricky process, but under the right circumstances it would enable you to "sell" the ocean property and exchange it for some other property that may be more suitable for you. Keep in mind, however, that the new exchanged property (called the replacement property by the Internal Revenue Service) must be held for investment purposes, and -- at least for a reasonable period of time -- cannot be used as your principal residence. Some taxlawyers say the "safe harbor" is one year, while others say two years.

These are but a number of the options you should consider so as to avoid paying a considerable amount of money to Uncle Sam.

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