A colleague of mine recently bought a new property located a few states away that he plans to use as a vacation home. The property sounds fantastic, complete with an outdoor pool, hot tub, and game room. As we discussed the acquisition, my colleague asked how his new home would be considered for tax reporting. What if it’s rented for part of the year? Is it considered a residence?
The question got me thinking about the somewhat complex subject of vacation homes and section 1031. As we know, section 1031 encompasses property held by a taxpayer for productive use in a trade or business or for investment. Given this requirement, you might suppose that a vacation home would automatically be disqualified from falling within the scope of section 1031. In reality, a vacation home may actually qualify for 1031 treatment provided that certain guidelines are followed. The issue of vacation home eligibility is an important one because those who use section 1031 are more likely to own vacation property.
Let’s examine the guidelines that determine whether you can use your vacation home in a 1031 exchange.
Can You Use Your Vacation Home in a 1031 Exchange? Eligibility Lies in Intent
At first glance, it may seem like vacation homes are generally ineligible for section 1031 treatment. However, the reality is more nuanced. Vacation homes may qualify for 1031 treatment, but the burden is on the taxpayer to prove that the vacation home qualifies as an investment property.
If the vacation home is found to be a residence, then the home is barred from section 1031 treatment. Whether a particular vacation home is classified as either a personal residence or investment property depends ultimately on the underlying intent behind the acquisition and operation of the property. And there are two main indicators that make up your intent: personal use and rental activity.
If you rarely use your vacation home, this alone is conducive toward the claim that the property is not a personal residence but may be held for investment purposes. And if it is rented out—especially on a regular basis throughout the year (more on that later)—then you can make an even stronger case that you acquired your vacation home with an investment intent.
As with other issues of section 1031, there’s no mathematical formula that can be used to determine exactly how a given property will be classified; but these two things will certainly give you a good sense of how your property will be viewed for tax purposes.
The Expectation of Gain by Itself Is Insufficient to Establish Investment Intent
There’s no question that it’s important for you to be aware of the factors that will help establish investment intent. With that being said, it’s also very important to understand what will not help you establish this kind of intent. Whenever someone purchases a vacation home—or any home, for that matter—he or she usually expects (or hopes) that the vacation home will appreciate in value over time.
You might think that this expectation of appreciation in value is enough to show investment intent. This would seem logical because if there’s appreciation, then there could be a substantial gain following a sale and so it would appear that the taxpayer had made a clear investment in the property. In actuality, however, this argument has been held to be unacceptable by the tax court.
The basic problem with this argument is that it doesn’t account for the purpose of the property. The mere existence of an expectation of appreciation in value tells us nothing about the reason underlying the property’s acquisition and operation. If the expectation of appreciation were enough to demonstrate investment intent, then we could conclude that nearly every property would qualify for section 1031 treatment. This simple expectation is insufficient: there must be more evidence that speaks to the true purpose of the property.
In 2007, the tax court ruled on this matter specifically in the case of Moore v. Commissioner. In the Moore case, the property owners sold their vacation home, acquired another one, and then attempted to include this transaction as a 1031 exchange. The court rejected this attempt and ruled that, although the initial property may have been sold for a profit, the mere expectation that a property could be sold for profit at a future date did not warrant section 1031 treatment. The determinative fact of the case was that the owners treated their vacation home as a residence rather than an investment property.
Revenue Procedure 2008-16 Establishes Guidelines for Vacation Homes
Fortunately for you and other investors, the IRS developed Revenue Procedure 2008-16 for vacation home owners. This document sets forth clear guidelines for making sure that your vacation home qualifies for a legitimate section 1031 exchange. If you abide by these guidelines, the IRS will not likely challenge your vacation home 1031 transaction. It’s still possible for a vacation home to be included as part of a 1031 exchange if these conditions are not met; however, satisfying these conditions will increase the probability of your section 1031 qualification.
If you want to use your vacation home in a 1031 transaction, you must follow two rules:
- During either the 24 months prior to selling your vacation home, or the 24 months after purchasing your vacation home, you must have rented the vacation property for at least 14 days during each 12-month period in the 24-month timeframe.
- You can’t use the vacation property yourself for more than 14 days, or more than 10 percent of the days it is rented, during each 12-month period of the 24-month window.
Satisfying these conditions is equivalent to demonstrating to the IRS that you acquired the vacation property with investment intent.
As I pointed out earlier, vacation home eligibility for section 1031 treatment is a common issue for investors. Regardless of the situation, it’s always helpful to obtain expert counsel on such issues. CWS Capital Partners has a wealth of experience dealing with 1031 exchanges and vacation homes. We can help you determine whether your vacation home is eligible, and we can assist you throughout the entire 1031 exchange process.
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