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1031 Exchange Of Vacation Property Or Second Home May Qualify

One of the questions often asked is whether an investor can 1031 Exchange out of a vacation property or second home ("relinquished property") and into other "qualifying use" investment property, vacation property or second home ("like-kind replacement property") on a tax-deferred basis using a 1031 Exchange?

There has always been varying opinions among 1031 Exchange experts as to whether real property held and used for personal use and enjoyment such as vacation properties or second homes could be exchanged for other "qualifying use" investment properties on a tax-deferred basis pursuant to Section 1031 of the Internal Revenue Code

Background Of 1031 Exchanges Of Vacation Homes: A History Of Contradiction

Private Letter Ruling 1981-03117

Private Letter Ruling PLR 198103117 was issued in 1981 by the Internal Revenue Service and indicated that an investor could 1031 Exchange out of vacation property and into investment property if it was held for investment as well as personal enjoyment.  Our concern is that the PLR is an old PLR that was issued a decade before the Deferred Exchange Regulations were issued. 

Deferred Exchange Regulations

The Department of the Treasury issued the Deferred Exchange Regulations in 1991, which seemed to contradict the Private Letter Ruling by making it clear that property must be held for investment or use in a business.  The Deferred Exchange Regulations led many 1031 Exchange experts to think that 1031 Exchanges of vacation property or second homes would not qualify for tax-deferred exchange treatment unless it was demonstrated that the intent was to hold the subject property for rental, investment or use in a business. 

Tax Court Memorandum 2007-134

Additional guidance was not provided until Tax Court Memorandum 2007-134 (TCM 2007-134) was filed on May 30, 2007.  TCM 2007-134 held that the 1031 Exchange did not qualify for tax-deferred exchange treatment because the investor's real intent was to acquire, hold and use the property for personal use and enjoyment and not for investment or business use purposes.

We now know based on Tax Court Memorandum 2007-134 that the primary intent of the investor is the critical factor in determining whether a property was held for personal use and enjoyment or whether it was held for investment purposes regardless of whether a secondary intent was present.  It also appears that the investor's intent at the time of the disposition (sale) of the real estate is the key issue in determining whether your intent was to hold for personal use and enjoyment or for rental, investment or business use.  The investor's original intent at the time they originally acquired the real estate does not seem to be relevant. 

The Technical Issue In Question

The primary issue that needed to be addressed and clarified by the Internal Revenue Service ("IRS") was whether a vacation property, a second home or a primary residence that had been converted to investment or business use property would be considered "qualified use property" and therefore qualify for 1031 Exchange treatment or whether it was merely being held for personal use and enjoyment and would therefore not qualify for tax-deferred exchange treatment. 

Treasury Inspector General Criticizes IRS

The Inspector General of the Department of the Treasury issued a report in September 2007 entitled "Like-Kind Exchanges Require Oversight to Ensure Taxpayer Compliance", which recommended additional oversight of 1031 Exchanges by the IRS.  It specifically addresses the lack of oversight and guidance regarding 1031 Exchanges of vacation property and second homes. 

IRS Issues Guidance On 1031 Exchanges Of Vacation Properties & Second Homes

The Internal Revenue Service issued Revenue Procedure 2008-16 in response to the Treasury Inspector General's Report.  The guidance provides specific safe harbor language that clarifies when your vacation home, second home or primary residence that was converted to investment property would be considered as "qualified use property" and therefore qualify for 1031 Exchange treatment pursuant to Section 1031 of the Internal Revenue Code.

Revenue Procedure 2008-16 Provides Safe Harbor Guidance

Revenue Procedure 2008-16, which is effective March 10, 2008, provides a number of safe harbor guidelines that would permit an investor to complete a 1031 Exchange of a vacation property or a second home.  It is important to note that Rev. Proc. 2008-16 only provides safe harbor language.  A 1031 Exchange of vacation property or a second home that falls outside of the safe harbor guidelines may still qualify for tax-deferred exchange treatment depending upon the circumstances. 

Vacation Homes or Second Homes Held as Relinquished (Sale) Properties

The sale of a vacation property or a second home will qualify for tax-deferred exchange treatment if the following safe harbor requirements have been met:

  • The subject property has been owned and held by the investor for at least 24 months immediately preceding the 1031 Exchange ("qualifying use period"); and
  • The subject property was rented at fair market rental rates to other people for at least 14 days (or more) during each of the preceding two (2) years; and
  • The investor limited his or her personal use and enjoyment of the property to not more than 14 days during each of the preceding two (2) years, or ten percent (10%) of the number of days that the subject property was actually rented out to other people during each of the preceeding two (2) years. 

Vacation Homes or Second Homes Acquired as Like-Kind Replacement Property

The purchase of a vacation property or a second home will qualify as replacement property in a tax-deferred exchange transaction if the following safe harbor requirements are met:

  • The subject property is owned and held by the investor for at least 24 months immediately following the 1031 Exchange ("qualifying use period"); and
  • The subject property was rented at fair market rental rates to other people for at least 14 days (or more) during each of the following two (2) years; and
  • The investor limits his or her personal use and enjoyment of the property to not more than 14 days during each of the following two (2) years, or ten percent (10%) of the number of days that the subject property was actually rented out to other people during each of the following two (2) years. 

Personal Use Of The Property By The Investor

Use of the subject real property by the investor or their family members will be considered "personal use" by the investor.   Arrangements where fair market rent is not paid to the investor will also be considered "personal use" by the investor.

However, use of the subject property will not be considered to be "personal use" by the investor if the family members pay fair market rental rates to the investor and the subject property is their primary residence.

Fair market rental rates are based upon all of the facts and circumstances that exist when the rental or lease agreement is entered into.  All rights and obligations of the rental or lease agreement are also taken into account.

1031 Exchange May Still Be Possible If Outside The Safe Harbor Guidelines

1031 Exchanges of vacation properties or second homes that do not follow the safe harbor guidelines provided within Rev. Proc. 2008-16 may still qualify for tax-deferred exchange treatment under Section 1031 of the IRC.  Investors should consult with their legal and tax advisors to determine whether their real property would be considered held for rental, investment or use in a trade or business in order to qualify for 1031 Exchange treatment. 

Conclusion

The issuance of Revenue Procedure 2008-16 has certainly helped clarify when vacation properties and second homes will qualify for tax-deferred exchange treatment.  Rev. Proc. 2008-16 still leaves some questions unanswered, especially if you do not fall within the safe harbor guidelines.

You must carefully analyze and evaluate each of your transactions on a case-by-case basis with your legal and tax advisors to determine if your specific fact pattern complies with Rev. Proc. 2008-16 or would support a position that your vacation property or second home was in fact held for rental, investment or business use and would therefore qualify for tax-deferred exchange treatment.

Certainly, the more rental, investment or business use activity the stronger your argument will be that you had the intent to hold for rental or investment.  The more proof you have that the property was held, treated and reported as rental or investment property, the better your position will be to support tax-deferred exchange treatment.  The more personal use, of course, the weaker your argument.  Proactive planning can help position your property and transaction better for a future tax-deferred exchange structure as well.

 

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