Vacation Homes May Qualify for
Tax Deferred 1031 Exchanges
By Tom McMillen,
Professional Exchange
Accommodators, L.L.C.
A common question our clients ask is whether their vacation home qualifies for a 1031 tax deferred exchange. The answer of course is “yes” and “no” and “maybe”.
There is no question that a rental property used fewer than 14 days a year by the owner, and rented out the rest of the year, is investment property and qualifies for a 1031 exchange.
But what if a vacation home is not rented out, but is held and used only by the owner? Is it “investment property” for 1031 purposes? Since there has been no guidance from the IRS, the experts fall into two camps: those who believe it is 1031 property and those who don’t.
Those who believe that it is 1031 property point to the definition of qualified “like kind” property in the Regulations: “Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale.”
This language was adopted by the IRS in 1956 and has remained unchanged since then. Thus, unproductive raw land with no improvements, held solely for purposes of realizing an increase in value, certainly qualifies for a 1031 exchange. But does personal use of the property as a vacation home by the owner disqualify it for a 1031 exchange?
More recently, in a 1981 Private Letter Ruling, the IRS allowed Section 1031 treatment of a vacation home where the taxpayer intended to acquire property for personal enjoyment and as an investment. The IRS stated, “The house and lot you acquire in this trade will be held for the same purposes as the properties exchanged therefor: to provide for personal enjoyment of the community and to make a sound real estate investment.” This Private Letter Ruling would seem to support the argument that “personal enjoyment” of a property does not prevent it from qualifying for a 1031 exchange.
And a United States Tax Court case held that the fact that a property does not produce current income does not disqualify it from being treated as “investment property.”
On the other hand, by way of analogy, some 1031 Experts point to Section 280A of the Code which governs the deductibility of losses from a vacation or second home. Section 280A provides that a taxpayer may not deduct losses with respect to a dwelling unit used as a residence by them during the taxable year. And it defines a dwelling unit as a residence if a taxpayer uses the unit for personal purposes for a number of days which exceeds the greater of 14 days or 10% of the number of days during the year for which the unit is rented for fair market value. For these purposes, personal use includes the use of the unit by persons related to the taxpayer, unless the related persons use the unit as a principal residence and they are paying fair rental. This definition also applies to determine if a taxpayer may deduct the mortgage interest related to a property as a “second home.”
If Section 280A does not limit the application of Section 1031 to vacation homes, then some experts also point to Section 165 as another potential disqualifer. The general rule under IRC Section 165 is that losses may be deducted if the transaction was entered into for profit. A profitable sale must be the primary motive, not a secondary motive.
To be safest, a taxpayer desiring to exchange their ownership in a vacation home under Section 1031 should either not use the property for more than 14 days or should rent, (or make the property available for rent) during the year prior to the sale. They should also make it clear to their CPA and attorney, that their property is held primarily for investment and secondarily for personal use. 
IRS Reg. 1.1031(a)1(b).
Private Letter Ruling 8103117.
Ray v. Commissioner, Docket No. 36379-85 (11/27/89.)
Tom McMillen is a 1031 exchange specialist with Professional Exchange Accommodators, L.L.C. With over 15 years of experience as a practicing attorney, he devotes his energies to helping property owners defer income tax on the sale of their investment property. Professional Exchange Accommodators is one of the nation’s largest Qualified Intermediary firms and handles approximately 8,000 straight exchanges and 350 reverse exchanges a year and has Florida offices in Naples and Tampa. He can be reached at their Denver office at 1-800-895-3520, or through their web page at www.exchangecpas.com.
| back to top |
|
