A 1031 exchange allows the taxpayer to defer indefinitely federal and state capital gain and recaptured depreciation taxes that may represent a tax of up to forty percent of the net sales price. The Internal Revenue Service (IRS) Section of the tax code is used by taxpayers who own real and tangible and intangible personal property such as vacation and commercial property, aircraft, equipment, collectible vintage cars, artwork or franchise rights, that is held in the productive use of a business or for investment. When the property is sold and conveyed at closing or escrow, the capital gain tax obligation is triggered that can be deferred or pushed forward if a 1031 exchange is initiated prior to or at closing. A replacement property of equal or greater value must be acquired within 180 calendar days or the partial tax or full tax is due. The 1031 tax code also applies to property held internationally when replaced with property held overseas.
Vacation Property and Personal Use
Often a vacation property is acquired, held as a rental and sold, capital gain taxes are deferred in a 1031 exchange. To qualify for a 1031 exchange, the IRS issued Revenue Procedure 2008-16, effective March 10, 2008, providing a safe harbor that if satisfied, the IRS will not challenge whether the vacation home qualifies as property held for productive use in a business or for investment. The Revenue Procedure requires vacation property to be rented at least fourteen overnights or ten percent of the number of days the property is rented at fair market rental per year for each of two years preceding the 1031 exchange. Personal use must not be greater than fourteen overnights in each of the two years. Renting to family members to satisfy the fourteen rental overnights is not permitted and problematic. If the taxpayer is providing maintenance or repairs as supported by receipts, work reports and time logs, the overnight does not count towards the fourteen night personal use threshold. If a vacation home is acquired as the replacement property in a 1031 exchange, the two year fourteen rental requirement and personal use limitation is in effect.
Personal Use Exceeds 14 Overnights
What if personal use exceeds fourteen overnights? Though outside the safe harbor, Internal Revenue Code Section 280A(e)(1) generally allows deductions for the property based on the ratio of the number of days used as a rental to the number of days used as the taxpayer’s dwelling unit or second home. To be within the safe harbor, wait two years prior to selling to re-characterize the use from a second home to a rental property, restricting personal use to no more than fourteen overnights and renting the property at least the fourteen night requirement. Taxpayers who elect not to follow the Revenue Procedure 2008-16, initiating a 1031 exchange without satisfying the safe harbor, should file an amended return and not report as an exchange. Plan ahead, be aware of the rule; otherwise, be prepared to assume the risk.
Investment Intent Not Sufficient
Vacation homes held primarily for the personal use of the owner or related parties are not eligible for a 1031 exchange. Abandoning personal use will not convert the property to investment use given the use is abandoned in order to sell the property. The taxpayer who never rents the property should, in order of importance (a) satisfy the safe harbor requirements of fourteen rental nights and limited personal use of fourteen overnights per year (b) place the property into a vacation rental pool or advertise to support rental intent (c) avoid personal use in the year prior and after the exchange along with not listing the relinquished property for sale in the same timeframe to show an investment intent (d) do not make improvements for taxpayer’s use and avoid maintaining personal items on the premises such as a boat or recreational vehicle (e) itemize the vacation property on Schedule E of the taxpayer’s federal return, deducting investment interest under Section 163(d) and (f) conduct yearly maintenance and repairs when not using it for personal use.
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