SETTING UP A VACATION HOME 1031 EXCHANGE

UNDERSTAND IF YOU QUALIFY FOR A VACATION HOME 1031 EXCHANGE

VACATION HOME 1031 EXCHANGES

DOES YOUR VACATION HOME QUALIFY FOR a TAX DEFErred Exchange?

hurdle

THE HURDLE

By definition, vacation homes are typically held for personal use. Generally, vacation homes are in a vacation destination away from your main home. As a result, tax professionals commonly declare it for personal use. Common reasons are being in a warm weather location, recreational uses, and no mentions of investment activity.

THE OPPORTUNITY

What if you rent or try to rent your property when it's vacant? Does your property qualify? Section 1031 does not define investment. Although, Code Section 280 states presents guidelines for renting out the property. Section 280 states that using the property more than 14 days of the year or 10% of the time rented means that you cannot deduct the loss associated with operating the unit.

1031 Exchange Qualified Intermediary to Facilitate 1031 Like-Kind Exchanges Accomodator

THE OUTCOME

There is no clear path between the two code sections, 1031 and 280. However, the IRS tried to define investment activity within section 280, and may lean on it during an audit. So how can you qualify your vacation home for a 1031 exchange? How you handle your investment property expenses on your tax return may determine if your property qualifies as investment for a 1031 exchange. As an example we have two relevant court rulings below to provide guidance. Additionally, we explain the Safe Harbor Rule for Vacation Home 1031 Exchanges.

INVESTMENT PROPERTY QUALIFICATION COURT RULING GUIDANCE

RIVERA v. COMMISSIONER (2004)

The taxpayers in this case used the property for personal use and never rented the property. The court ruled for the taxpayer allowing the exchange based on testimony they purchased the property with the expectation it would increase in value. This argument satisfies the investment criteria of 1031 per the court.

MOORE v. COMMISSIONER (2007)

The taxpayers used the property personally over four months per year. They kept the property vacant for the rest of the year. The taxpayers never rented it, and personally deducted all of the expenses on their tax return. The taxpayer testified they bought the property expecting it would increase in value as in Rivera, but the court challenged and determined the property was held personally, disallowing the exchange. The court said if they handled the expenses differently on their tax return, they might have agreed.

(T.C. Memo 2007-134, 5/30/07),

SAFE HARBOR RULE FOR VACATION PROPERTY 1031 EXCHANGES

Revenue Procedure 2008-16, effective march 10, 2008

The Safe Harbor Rule provides a number of guidelines that permit you to complete a 1031 of your vacation property or second home.  It is important to note that Rev. Proc. 2008-16 only provides safe harbors and that a 1031 exchange of a vacation home or second home that falls outside of the safe harbor guidelines may still qualify for a 1031.

Safe Harbor Rule Requirements

REQUIREMENT #1

The relinquished and replacement property is held for at least 2 years prior to the exchange for the old property, and 2 years after the exchange for the new property.

REQUIREMENT #2

The property is rented out for at least 14 days each year at fair market value.

REQUIREMENT #3

Used for personal use for no more than 14 days or 10% of the total amount of days rented per year (i.e. if one year the property is rented out for 200 days, the taxpayer may use it personally for no more than 20 days in that same year)

Note the words “personal use” in the third requirement of a safe harbor exchange. One question many people ask us is if this includes days you’ve spent at the property preparing it for renters (i.e. buying furniture and supplies, doing improvements, making repairs, etc.). This is a great question, as many property owners know it can easily take more than 14 days per year to prepare a property for tenants. The answer is no—any days used to make improvements or prepare the property for tenants do not count towards your 14 days or 10% of total days rented that year. To prove that you spent those days making improvements and not relaxing by the beach, simply keep records, such as receipts, to show that your time spent that day to prepare your property for tenants.

Under these guidelines, you can be assured the IRS will not question if your properties in a 1031 qualify as held for investment. What if you have rented out your investment property, but don't meet these exact guidelines—is a 1031 exchange still possible? The answer is most likely yes. Safe harbor is just a strategy written by the IRS to keep you “safe,” but is not required for a 1031 exchange.