During the spring of 2007, IRS provided important guidance regarding the exchange of vacation homes in Moore v. Commissioner, T.C. Memo (2007-134) under section 1031. In this case, the taxpayer acquired a vacation home on a lake a few hours drive from their home. The family visited the property almost every weekend between April and September for several years. After the family relocated and the drive was a few hours longer, they stopped using the property at all. The taxpayer exchanged the property for another lake property that was just a few hours’ drive from their principal residence and taxpayer resumed their pattern of using the property almost every weekend during the warm months. Neither property was ever rented. The exchange was challenged and the taxpayer unsuccessfully argued that they held the property for investment and it should qualify. The exchange failed and IRS said holding a vacation home in part with an expectation of profit is insufficient to justifythat the properties were held for investment.
In September 2007, the Office of the Treasury Inspector General of Tax Administration (TIGTA) issued a report stating a need for more oversight of 1031 exchanges. The report advised IRS to provide taxpayers with guidance on the exchange of vacation homes and it also recommended IRS conduct a study of exchanges. A study generally implies the IRS will begin auditing 1031 exchange transactions. The report also targeted those that promote the exchange of vacation homes which could include attorneys, tax advisors, real estate agents and qualified intermediaries.
As promised, the IRS has provided guidance on the exchange of vacation homes in the form of a “safe harbor” provided in Revenue Procedure 2008-16 and creates the ability for vacation home owners of exchanging for another vacation home. To qualify for the protection of the “safe harbor,” the taxpayer must follow all of the rules. A summary of this new safe harbor is as follows:
- Taxpayer owns the relinquished property for at least 24 months before selling;
- Taxpayer rents the relinquished property for at least 14 days for each of the two 12-month periods immediately preceding the sale;
- Cannot rent to a related party unless it is a year rental and related party uses the property as his/her primary residence; and
- Taxpayer cannot use the property for personal use more than 14 days or 10% the number of days the property was rented, whichever is greater.
- Taxpayer must rent the replacement property for at least 14 days for the two 12-month periods immediately following the acquisition;
- Cannot rent to a related party unless it is a year rental and related party uses the property as his/her primary residence;
- Taxpayer cannot use the property for personal use more than 14 days or 10% the number of days the property was rented, whichever is greater; and
- If taxpayer is unable to satisfy the requirements on the replacement property, he/she must amend his/her return and report the sale of the relinquished property as a taxable sale and not a 1031 exchange.
As with all investment properties, you may be able to stay at the property while making improvements or for business use reasons without it being considered personal use but you should seek guidance from your tax advisor.
The new Revenue Procedure provides planning opportunities for those who own vacation homes and want to exchange it for a more desirable property without capital gains. A taxpayer can establish a long-term plan to sell a vacation home, minimize personal use of the property to no more than 14 days per year and rent the property for a minimum of 14 days per year for the two 12 month periods preceding the anticipated sale. Taxpayers can still enjoy the week of Fourth of July and the other two long Holiday weekends and qualify. While it does prevent the property owner from enjoying the properties year round for four full years, it may be well worth it to defer tens or hundreds of thousands in capital gains.