Many taxpayers own vacation homes that they've rented out and also used as their personal residences. Can one of these homes be traded for another vacation home in a tax-deferred Section 1031 exchange? According to the IRS, the answer is "yes" under the right circumstances. The IRS has even issued guidelines for how to do it. (IRS Revenue Procedure 2008-16)
Tax Court: Anticipated Future Appreciation Does Not Constitute An Investment Property
In one Tax Court case, the taxpayers exchanged a lakeside vacation home in Georgia for another residence. Neither home was ever rented. Both were used by the taxpayers for personal purposes only.
The taxpayers argued that the exchange of the homes was a Section 1031 like-kind exchange because the properties were expected to appreciate in value and were therefore held for investment.
The Tax Court ruled, however, that the "primary purpose" in acquiring and holding both properties "was to enjoy the use of those properties as vacation homes."
It added: "The mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence." (Moore, TC Memo 2007-134)
This article explains how to qualify for IRS-approved Section 1031 exchanges of "mixed-use" vacation properties, which have been rented out as well as used for personal purposes.
Section 1031 Exchange Basics
To execute a legitimate tax-deferred Section 1031 exchange, you must swap property that you've held in the past for business or investment purposes for other like-kind property that you will hold in the future for business or investment purposes. This seems pretty simple.
However, years ago, it was unclear if the IRS would agree that a mixed-use vacation property could be considered property held for business or investment purposes. That uncertainty was removed when Revenue Procedure 2008-16 established specific safe-harbor guidelines for swaps of vacation homes used for personal purposes, as well as for business or investment reasons.
If you can meet the guidelines, the IRS will agree that your vacation home swap qualifies as a tax-deferred Section 1031 exchange (assuming you also meet all the other rules).
For the relinquished property (the mixed-use vacation property that you give up in the swap), you must pass both of the following tests:
1. You must have owned it for at least 24 months immediately before the exchange.
2. Within each of the two 12-month periods within the 24 months immediately preceding the exchange:
- You must have rented out the property at market rates for at least 14 days, and
- Your personal use of the property cannot have exceeded the greater of 14 days or 10 percent of the days the property was rented out at market rates. The most recent 12-month period ends on the day before the exchange takes place and begins 12 months prior to that day. The earlier 12-month period ends on the day before the most-recent 12-month period begins and ends 12 months prior to that day.
Key Point: One principle remains unchanged. A property that you've used primarily for personal purposes cannot be swapped in a tax-deferred Section 1031 exchange.
Similar safe-harbor guidelines must be met for the replacement property. You must continue to own it for at least 24 months immediately after the exchange and meet rules for rental and personal use.
Beware: Only "Dwelling Units" Qualify
The safe-harbor provisions established by Revenue Procedure 2008-16 are only available for "dwelling units." For this purpose, the IRS defines a dwelling unit as a piece of real property that comes with a house, apartment, condominium or similar place that furnishes basic living accommodations — including sleeping space, bathroom and cooking facilities.
Too Much Personal Use Can Make You Ineligible
There is another caution: Too much personal use of either the relinquished property or the replacement home can make you ineligible for the safe-harbor provisions established by IRS Revenue Procedure 2008-16. In that case, the IRS would have the right to challenge the treatment as a legitimate tax-deferred Section 1031 exchange.
So what counts as personal use? According to the Revenue Procedure, personal use occurs whenever your property is used for any part of a day in the following ways:
Key Point: Under an exception, the use of your property as another person's principal residence (including someone who is a member of your family) doesn't count as personal use if that person pays you market rent.
Can You Benefit?
The IRS stated in Revenue Procedure 2008-16 that it "recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes." The safe-harbor provisions established by the guidance are available for swaps of mixed-use properties that occur on or after March 10, 2008. For earlier swaps, consult with your tax advisor to determine if tax-deferred Section 1031 treatment applies.
In addition, your advisor can help you plan ahead to meet the guidelines for swaps that have not yet occurred.