As a general rule, when a taxpayer sells real property and realizes a gain on the property, the taxpayer is required to pay capital gains taxes on the gain realized. Although the rate at which capital gains are taxed fluctuates, it is typically enough to warrant looking for legal mechanisms to avoid the obligation. One mechanism used by many taxpayers is a Section 1031 Exchange. Named after the IRS section from which it stems, a Section 1031 contemplates an “exchange” of property instead of an outright sale. When a transaction qualifies for a Section 1031 Exchange, capital gains taxes on the realized gain are deferred. Can the sale of a vacation property qualify for Section 1031 treatment? If certain conditions are met, the answer is “yes.”
Vacation Property
In pertinent part, Section 1031 reads “no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment.” Since a vacation home is clearly not used “for productive use in a trade or business”, the question then became whether or not a vacation home qualifies as an investment. Although many taxpayers purchase a vacation home with the expectation that the property will appreciate in value, they also plan to use the property for personal use, making an argument for both a conclusion that the home is a personal residence and that it is an investment. The IRS settled the issue once and for all with Revenue Procedure 2008-16 which provides a safe harbor for taxpayers who wish to enter into a Section 1031 Exchange with a vacation home property.
Revenue Procedure 2008-16
Under Rev. Proc. 2008-16, the IRS agreed not to challenge whether or not a vacation property was held as an investment for purposes of a Section 1031 Exchange if the following conditions are met:
- The property to be relinquished was held by the taxpayer for at least 24 months prior to the exchange
- Within the required 24 month period, the property was rented at fair market value for at least 14 days within each of the two 12 month periods that make up the 24 month holding period
- The taxpayer’s personal use of the property did not exceed the greater of 14 days or 10 percent of the time the property was rented during each 12 month period
- The replacement property must also be held for at least 24 months with the same rental versus personal use rules
Interestingly, HR Rep No 3150, 100th Congress, 1st Session (1989) would have required the relinquished and replacement property in any 1031 qualifying exchange to be held for at least one year before the exchange but it was not included in the Omnibus Budget Reconciliation Act of 1989.
Rev. Proc. 2008-16 essentially creates a safe harbor for taxpayers who wish to take advantage of a Section 1031 Exchange when disposing of a vacation home. By the IRS agreeing ahead of time not to challenge whether the property is an investment, a taxpayer can plan accordingly and ensure that all other conditions are met in order to be able to take advantage of a Section 1031 Exchange.
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