1031 Exchange Rules for Vacation Homes
2007 Tax Court Decision on Vacation Home Exchanges
Before the US Tax Court addressed the issue of vacation home exchanges in Moore v. Commissioner (TC Memo 2007-134), there was no specific guidance about what was required to establish that a vacation home was held for investment purposes. For many years, the taxpayers in Moore used their lakefront vacation property almost every weekend for personal purposes. They never rented nor attempted to rent the property. They did not treat the property as investment property on their tax return (specifically, they deducted the mortgage interest as home mortgage interest rather than investment interest and did not deduct any other property expenses as investment expenses). Their only argument for treating the property as being held for investment was that they expected the property to appreciate in value. The Tax Court was not persuaded and held that investment intent must be a primary reason for holding the property. The court found that the Moores held the property primarily for their own personal use and enjoyment.
Revenue Procedure 2008-16 – Safe Harbor for Exchange of Vacation Homes
On February 15, 2008, the IRS addressed the issue of whether a vacation home qualifies as being held for investment purposes. Rev. Proc. 2008-16 established a “safe harbor” for exchanges occurring on or after March 10, 2008. This means that the IRS will not challenge whether a property qualifies as investment property if the three requirements in the Rev. Proc. are met.
1. Ownership Test. The property must be owned by the taxpayer for at least 24 months before the exchange (or after the exchange for the replacement property).
2. Limited Personal Use. Within each of the two 12-month periods immediately before the exchange, personal use of the property must not exceed the greater of 14 days or 10% of the days the property is rented at a fair rental value. For replacement property, personal use must be limited for each of the two 12-month periods after the property is acquired. Personal use includes days of use by (1) any owner of the property, (2) any family member of an owner, (3) anyone who uses the unit under a reciprocal use arrangement, and (4) anyone who pays less than fair rental value but does not include days where the owner uses the unit for repairs and maintenance.
3. Rental Use Test. The property must be rented to an unrelated party at a fair rental for at least 14 days for each of the two 12-month periods immediately before the exchange (or after the exchange for the replacement property).
Strategies to Safeguard a Vacation Home Exchange
The most conservative strategy is to meet the safe harbor requirements. To do this, investors must plan in advance so that they will satisfy the three tests discussed above for any vacation properties involved with their exchange. However, failing to meet the safe harbor does not mean that the exchange will not qualify for 1031 exchange treatment. If a property owner chooses this path, he or she must be sure to establish a stronger case than the taxpayer did in Moore. The two main requirements are the same: limit personal use and show the property is held for investment.
As always, real estate investors should consult with their tax advisors to ensure proper interpretation of the rules in their situations. We are always happy to assist with this process.
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