When Do Vacation Properties and Second Homes Qualify for a 1031 Exchange?
The 1031 qualifications of vacation and second homes have long been a debated topic by investors and their advisors. Lacking specific written guidance, it was not always clear if such properties qualified as appropriate relinquished, or replacement, property for a §1031 tax exchange. Many taxpayers often exchanged vacation properties and second homes under the premise that the property qualified for tax deferral because it was purchased for investment purposes, either as an occasional rental or as an appreciation play and was not their primary residence. Such properties were deemed to have a dual use- to hold the property for both personal and investment purposes.
In recent years, the IRS and Tax Courts have further clarified the qualifications in tax court rulings and, more importantly, the issuance of Revenue Procedure 2008-16. Taxpayers and their advisors now have a much clearer picture of the desired qualifications to meet the eligibility standards for a 1031 exchange.
In 2007 the Tax Court issued an adverse ruling disqualifying the exchange of a vacation home in Moore v. Commissioner (T.C. Memo. 2007-134). In its analysis, the court agreed with the Service that the taxpayer’s primary intent of ownership for the properties was for personal use, not investment, and thus denied the exchange.
Subsequently in 2007, the Inspector General of the Department of Treasury issued the report “Like-Kind Exchanges Require Oversight to ensure Taxpayer Compliance” which specifically addressed the lack of guidance with regards to vacation property and second homes. In response, the IRS issued Revenue Procedure 2008-16 providing guidance for assessing the suitability of a vacation property or second home for a tax deferred exchange. Rev. Proc. 2008-16 defined the “qualifying use standards” of a relinquished/ replacement property dwelling unit, providing a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031.
Rev. Proc. 2008-16 defines the qualifying use standards for the sale of a vacation property or second home dwelling unit as:
1. The dwelling in question must have been owned by the taxpayer for at least twenty four months immediately before the exchange (defined as the “qualifying use period”),
2. During each of those two years the taxpayer must rent the dwelling at a fair market amount for at least fourteen days, and
3. The taxpayer’s personal use of the property each year must not exceed more than fourteen days or 10% of the days that the property was rented.
The qualifying use standards for replacement property are the same as those for relinquished property for vacation property and second homes. Additionally, the Revenue Procedure suggests that if a taxpayer purchasing a replacement property expecting the property will meet the qualifications, but in actually does not, “if necessary, should file an amended return and not report the transaction as an exchange.”
Rev. Procedure 2008-16 is just a safe harbor. An exchange may still fall outside the parameters and meet the statutory requirements, but you should expect heightened scrutiny in such a case. The safe harbor is effective for exchanges occurring on or after March 10, 2008.