Can you 1031 exchange out of your vacation property or second home ("relinquished property") and into another "qualifying use" investment property, vacation property or second home ("like-kind replacement property") on a tax-deferred basis using a 1031 exchange?
There was extensive disagreement among 1031 exchange experts as to whether real property held and used for personal use and enjoyment such as vacation properties or second homes could be exchanged for other "qualifying use" investment properties on a tax-deferred basis pursuant to Section 1031 of the Internal Revenue Code.
Background of 1031 Exchanges of Vacation Homes: A History of Contradiction
Private Letter Ruling 1981-03117
Private Letter Ruling PLR 198103117 was issued in 1981 by the Internal Revenue Service and indicated that you could 1031 exchange out of vacation property and into investment property if it was held for investment as well as personal enjoyment. Our concern has always been that the PLR was an old PLR and issued a decade before the Deferred Exchange Regulations were issued.
Deferred Exchange Regulations
The Department of the Treasury issued the Deferred Exchange Regulations in 1991, which seemed to contradict the Private Letter Ruling by making it clear that property must be held for investment or use in a business. The Deferred Exchange Regulations led many 1031 exchange experts to think that 1031 exchanges of vacation property and second homes would not qualify unless it was demonstrated that the intent was to hold for investment or use in a business.
Tax Court Memorandum 2007-134
Additional guidance was not provided until Tax Court Memorandum 2007-134 (TCM 2007-134) was filed on May 30, 2007. TCM 2007-134 held that the 1031 exchange did not qualify for tax-deferred exchange treatment because the taxpayer's real intent was to acquire, hold and use the property for personal use and enjoyment and not for investment purposes.
We now know based on Tax Court Memorandum 2007-134 that the primary intent of the taxpayer is what determines whether a property was held for personal use and enjoyment or whether it was held for investment purposes regardless of whether a secondary intent was present. It also appears that your intent at the time of the disposition (sale) of your real property is the key issue in determining whether your intent was to hold for personal use and enjoyment or for investment. Your original intent at the time you originally acquired your real property does not seem to be relevant.
The Technical Issue in Question
The primary issue that needed to be addressed and clarified by the Internal Revenue Service was whether a vacation property, a second home or a primary residence that had been converted to investment property would be considered "qualified use property" and therefore qualify for 1031 exchange treatment or whether it was merely being held for personal use and enjoyment and would therefore not qualify for tax-deferred exchange treatment.
Treasury Inspector General Criticizes IRS
The Inspector General of the Department of the Treasury issued a report in September 2007 on 1031 exchanges entitled "Like-Kind Exchanges Require Oversight to Ensure Taxpayer Compliance" and has recommended additional oversight of 1031 Exchanges by the IRS. It specifically addresses the lack of oversight and guidance regarding 1031 exchanges of vacation property and second homes.
IRS Issues Guidance on 1031 Exchanges of Vacation Properties & Second Homes
The Internal Revenue Service issued Revenue Procedure 2008-16 in response to the Treasury Inspector General's Report. The guidance provides specific safe harbors that clarify when your vacation home, second home or primary residence that was converted to investment property would be considered as "qualified use property" and therefore qualify for 1031 exchange treatment pursuant to Section 1031 of the Internal Revenue Code.
Revenue Procedure 2008-16 Provides Safe Harbors
Revenue Procedure 2008-16, which is effective March 10, 2008, provides a number of safe harbor guidelines that would permit you to complete a 1031 exchange of your vacation property or second home. It is important to note that Rev. Proc. 2008-16 only provides safe harbors and that a 1031 exchange of a vacation home or second home that falls outside of the safe harbor guidelines may still qualify for tax-deferred exchange treatment.
Vacation Homes or Second Homes Held as Relinquished (Sale) Properties
A vacation home or second home that you have held and now wish to sell as your relinquished property in a 1031 exchange will qualify for tax-deferred exchange treatment if:
It is owned by the taxpayer for at least 24 months immediately before the exchange ("qualifying use period"); and
Within the qualifying use period, in each of the two 12 month periods, (1) the taxpayer rents the dwelling unit at fair rental to another person for 14 days or more and (2) the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12 month period that the dwelling unit was rented at fair rental value.
The first 12 month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day). The second 12 month period ends on the day before the first 12 month period begins (and begins 12 months prior to that day).
Vacation Homes or Second Homes Acquired as Like-Kind Replacement Property
A vacation home will qualify as like-kind replacement property if:
It is owned by the taxpayer for at least 24 months immediately following the exchange ("qualifying use period"); and
Within the qualifying use period, in each of the two 12 month periods, (1) the taxpayer rents the dwelling unit to another person at fair rental for 14 days or more and (2) the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12 month period that the dwelling unit was rented at fair rental.
The 12 month period immediately after the exchange begins on the day after the exchange takes place and the second 12 month period begins on the day after the first 12 month period ends.
Personal Use is Broadly Defined
Use by the taxpayer or other person having an interest in the dwelling unit and any family member will be considered "personal use" by the taxpayer. Also, any arrangement whereby fair market rent is not paid will be considered "personal use" by the taxpayer. Notwithstanding the foregoing, use by family members will not be considered "personal use" by the taxpayer only if the dwelling unit is rented at fair market rent and the family member uses it as his primary residence.
Fair rental is based upon all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the rental agreement are taken into account.
Special Rule for Like Kind Replacement Property
If the taxpayer files a return reporting a transaction under Section 1031 based on the expectation that the dwelling unit will meet the qualifying use standards and subsequently determines that the dwelling unit does not meet the qualifying use standards, the taxpayer, if necessary, should file an amended return.
1031 Exchange May Still Be Possible if Outside the Safe Harbor Guidelines
1031 exchanges of vacation properties or second homes that do not follow the safe harbors provided within Rev. Proc. 2008-16 may still qualify for tax-deferred exchange treatment under Section 1031 of the IRC.
The issuance of Revenue Procedure 2008-16 has certainly helped clarify the issue of 1031 exchanging vacation properties and second homes, but Rev. Proc. 2008-16 still leaves some questions unanswered, especially if you do not fall within the safe harbor guidelines.
You must carefully analyze and evaluate each of your transactions on a case-by-case basis with your legal and tax advisors to determine if your specific fact pattern complies with Rev. Proc. 2008-16 or would support a position that your vacation property or second home was in fact held for investment and would therefore qualify for tax-deferred exchange treatment.
Certainly, the more rental, investment or business use activity the stronger your argument will be that you had the intent to hold for investment. The more proof you have that the property was held, treated and reported as investment property, the better your position will be for a tax-deferred exchange. The more personal use, the weaker your argument.
Proactive planning can help position your property and transaction better for a future tax-deferred exchange structure as well.