We are often asked whether tax liability from the sale of a vacation home can be deferred using the procedures of IRC section 1031. The answer to this question is found in Revenue Procedure 2008-16.
The general rule for ALL 1031 exchanges is that the property must be held for primarily for investment of use in trade or business. In order to prove that your vacation home is held primarily for investment, and is therefore 1031 eligible, rather than for your own personal use the Internal Revenue Service (IRS) set out specific parameters for you to follow. This is known as a “safe harbor.” Those parameters are:
For the Relinquished or Old Vacation Property you must have:
Owned the property for at least two years, and;
In each of those two years, the property must have been rented for 14 days or more at fair market rent.
For the Replacement or New Vacation Property
Owned the property for at least two years, and;
In each of those two years, the property must have been rented for 14 days or more at fair market rent.
In addition to these “safe harbor” requirements there are additional requirements:
Your own use of the1031 exchange vacation homes must be no greater than 14 overnights or 10% of the days rented per year, whichever is less, but excluding time spent at the property for repair and maintenance.
The term “safe harbor” means that the IRS will not challenge your 1031 claim of tax deferral if you can prove these facts. The burden of proof is always on the taxpayer. If you 1031 exchange vacation homes and are unable to prove these precise facts your 1031 exchange may still be honored. But it will be subject to greater scrutiny by the IRS. When you do not meet the “safe harbor” test you can still prove investment intent by other facts and circumstances. Some of the best ways to prove investment intent are:
Keep an analysis of the property’s investment potential when you buy it. Market trends and resale potential are important parts of this analysis,
Schedule your vacation home on your tax return under your schedule E,
Take depreciation,
Show income from the property,
Keep track of your personal use time, and remember time spent on repair and maintenance is not counted as personal use time,
Make improvements to the property that will maximize its investment potential,
Do not list the property on schedule A of your tax return.
Show why you sold the property in less than two years makes sense from an investment point of view.
Keep in mind that when advanced planning is possible most taxpayers convert their personal use vacation property to property held primarily for investment under the above stated safe harbor rules prior to per forming a 1031 exchange. A second home can be converted to an investment property, changing the character by placing the property into a rental pool, reducing personal use and itemizing the property on Schedule E on tax return.
Vacation properties held in a 1031 exchange can be converted to a primary home in which case it could qualify for tax exemption under I.R.C. section 121. A second home can be converted to an investment property, changing the character by placing the property into a rental pool, reducing personal use and itemizing the property on Schedule E on tax return.
All of the other requirements of section 1031 exchanges apply to exchanges of vacation homes.
By,
Steven Hickox ESQ
