Vacation Homes and 1031 Exchanges

Can a vacation home qualify for a 1031 Tax-Deferred Exchange? Most tax and exchange professionals think so to the extent that the vacation home is used partly for rental purposes. For instance, if the vacation home is used 50% for personal use and 50% for rental or investment purposes, then 50% of the property is qualifying property held for investment purposes under IRC § 1031. The personal use portion of the vacation home will not be eligible for 1031 Exchange treatment. If the vacation home is used 100% for personal use, forget it _ it does not qualify under IRC §1031.

What if the vacation home is used partly for personal use and partly for investment purposes but is never rented out? In this case, the answer is “it depends.” It depends on the amount of personal use of the property by the taxpayer. Property held for personal use does not qualify as investment property (IRC § 1031(a)). However, mere incidental personal use of property that is otherwise considered investment property does not disqualify the property from 1031 Exchange treatment (PLR 8103117). “Incidental personal use” is not defined by the Code, Regs. or by other guidance issued by the IRS. Personal use of a vacation home for anything other than “incidental personal use” will disqualify a property if it is never rented out by a taxpayer.

Under what circumstances can all of the vacation home (100%) qualify for a 1031 Exchange? Code Section 280A(d) provides that a taxpayer’s dwelling is a 100% rental property (and not a “residence”) if the taxpayers personal use of the property is less than the greater of –

  • 15-days, or
  • 10% of the number of days during the year for which the dwelling is rented (at fair market value rents).

Personal use includes use by members of the taxpayer’s family. Personal use does not include work-days a taxpayer is at the residence. The purpose of IRC §280A is to limit deductions with respect to the rental use of a residence. Does 280A also define a property for purposes of a 1031 Exchange? Most tax and exchange professionals do not think so. However, compliance with the minimal personal use provisions under IRC §280A could be considered to be a “good bet” for qualification of the property as a 100% eligible property for 1031 Exchange treatment. Also, see (below) the new “safe-harbor” Rev. Proc. Issued by the IRS in March 2008 which uses language similar to IRC §280A.

If none of these rules will work for a taxpayer because of disqualifying personal use of the vacation home, then the taxpayer should consider converting the property to a qualifying investment property by discontinuing all personal use for a year or more to position the property for a 1031 Exchange. At the same time, be sure to report all of expenses related to the property as “investment related expenses.” Renting the property will be a definite help for this purpose but is not mandatory.

Safe Harbor – The IRS issued Rev. Proc. 2008-16 in March, 2008 for taxpayers who want assurance that their vacation home is a qualifying investment. The Rev Proc applies to any residence owned by the taxpayer in addition to a primary residence so it is broader in its application than to mere “vacation homes.” It is effective for exchanges of homes occurring after March 9, 2008.

The IRS says they will not challenge whether a residence qualifies as property held for use in a trade or business or for investment for purposes of §1031 if the following requirements are met:

The relinquished residence is owned by the taxpayer during the 24-month period ending on the day before the date of the exchange,
The replacement residence is owned by the taxpayer during the 24-month period beginning on the day after the date of the exchange, and
Within each of the two 12-month periods immediately before the exchange and within each of the two 12-month periods immediately after the exchange –
the residence is rented to another person or persons at a fair rental for at least 14 days, and
the period of personal use does not exceed the greater of 14 days or 10% of the days the residence is rented at a fair rental.

Personal Use – Rev Proc 2008-16 provides that personal use occurs on any day on which a taxpayer is treated as having used the dwelling unit for personal purposes under §280A(d)(2) (taking into account §280A(d)(3) but not §280A(d)(4)). Therefore, a taxpayer is generally treated as using a residence for personal purposes for a day if the unit is used for personal purposes by:

The taxpayer or any other person who has an interest in the dwelling unit or by a member of the family of the taxpayer or the other person;
Any individual who uses the unit under a reciprocal use arrangement; or
By any individual (other than an employee whose use is excludable from income under §119-Use for the convenience of the employer) unless, for that day, the dwelling unit is rented for a fair rental.

Fair Rental – A “fair rental” is determined based on all the facts and circumstances when entering the rental agreement

Failure to meet the new safe-harbor requirements does not mean that the exchange automatically does not qualify for §1031 treatment. But it does mean that the IRS could challenge the taxpayer’s exchange.

IRS Issues Safe Harbor for 1031 Exchanges of Residences
(Including Vacation Homes)

Rev Proc 2008-16 provides a “safe harbor” for dwelling units given and received in an exchange will qualify for §1031 treatment. This Rev Proc is only a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies as property held for use in a trade or business or for investment for purposes of §1031. Failing to meet the safe harbor should not mean that the exchange automatically does not qualify for §1031 treatment.

A dwelling unit is real property with a house, apartment, condominium, or similar improvement that provides basic living accommodations, including sleeping space, bathroom and cooking facilities. Therefore, a dwelling unit is a residence.

Safe-Harbor – The IRS says they will not challenge whether a dwelling unit qualifies as property held for use in a trade or business or for investment for purposes of §1031, if the following requirements are met:

  • The relinquished residence is owned by the taxpayer during the 24-month period ending on the day before the date of the exchange,
  • The replacement residence is owned by the taxpayer during the 24-month period beginning on the day after the date of the exchange, and
  • Within each of the two 12-month periods immediately before and after the exchange, the residence is rented to another person or persons at a fair rental for at least 14 days, and
  • the period of personal use does not exceed the greater of 14 days or 10% of the days the residence is rented at a fair rental.

Personal Use – Rev Proc 2008-16 provides that personal use occurs on any day on which a taxpayer is treated as having used the dwelling unit for personal purposes under IRC §280A(d)(2) (taking into account §280A(d)(3) but not §280A(d)(4)). Therefore, a taxpayer is generally treated as using a residence for personal purposes for a day if the unit is used by:

The taxpayer or any other person who has an interest in the dwelling unit or by a member of the family of the taxpayer or the other person;
Any individual who uses the unit under a reciprocal use arrangement; or
By any individual (other than an employee whose use is excludable from income under §119-Use for the convenience of the employer) unless, for that day, the dwelling unit is rented for a fair rental.