Taxpayers seeking to defer federal and state capital gain taxes in a 1031 exchange when selling their vacation home must determine whether the sale qualifies for tax deferral treatment. Often times, the taxpayer wishes to engage a Qualified Intermediary, or QI, to accommodate the exchange, only to discover their vacation property has not been held as an investment property. The tax consequence, depending upon the realized gain, may be as high as 40 percent of the sales price.
Facts Supporting a 1031 Exchange
A vacation property can be a condominium, single family residential, houseboat (county dependent) or cabin located anywhere in the world. Given the taxpayer is subject to US federal capital gains, the sale triggers federal and potentially state capital gain and 25 percent recaptured depreciation taxes. If depreciation is not taken by the taxpayer, the 25 percent tax is still due. Personal use should not exceed fourteen overnights per year or 10 percent of the time rented. Once the personal use threshold is surpassed, the property begins to take on the characteristics of a second home. Question 2 on Schedule E of the taxpayer’s 1040 federal return, asks the number of personal use days. Depreciation expense or depletion is found on line 18 of Schedule E. Each year the taxpayer may offset income by claiming depreciation on the rental property. Rental revenues and expenses are also listed on Schedule E. The facts of minimal personal use, rental revenues and itemizing the property on Schedule E support the intent to hold the vacation property as an investment.
A second home is reported on Schedule A of the taxpayer’s federal income return and can be used as the taxpayer wants without requirements to meet a particular IRS code. Second homes can be converted to an investment property and subsequently eligible for a 1031 exchange when the fact set meets the following guidelines.
Effective March 10, 2008, Revenue Procedure 2008-16 provides a safe harbor test, that if the taxpayer satisfies, the IRS will not challenge whether the vacation home qualifies as property held for the proper intent or productive use in a trade, business or investment under Section 1031. The requirements include:
Relinquished Property
Taxpayer owns investment property for 24 months and in each of the 12-month periods, the taxpayer rents the property to another person or persons at fair market rent for 14 days or more, and the taxpayer’s personal use does not exceed the greater of 14 overnights or 10 percent of the number of days rented annually at fair market value.
Replacement Property
Taxpayer owns replacement property for 24 months and in each of the 12-month periods, rents the property to another person or persons at fair market rent for 14 days or more, and the taxpayer’s personal use does not exceed the greater of 14 overnights or 10 percent of the number of days rented annually at fair market value.
To support fair market rent, a rental agreement should be in place covering rights and obligations of the participants. Comparable rental rates support the fair market rent. If friends (family members are not allowed) rent without paying fair market rent, then those days count towards the taxpayer’s personal use. If the taxpayer is performing maintenance on the property, those overnights do not count towards personal use.
Second Home
A second home is not eligible for a 1031 exchange. Abandoning personal use does not automatically qualify the vacation property for a 1031 exchange prior to the sale. In Moore v. Commissioner, T.C. Memo 2007-134, the Tax Court considered holding a property primarily for investment. The Court determined that the fact pattern “overwhelmingly demonstrates that [taxpayers’] primary purpose in acquiring and holding both [vacation homes] was to enjoy the use of those properties as vacation homes; i.e., as secondary, personal residences.”
The decision to not satisfy the safe harbor test in Revenue Procedure 2008-16, exposes the taxpayer to IRS challenging the 1031 exchange and potentially losing on a fact and circumstance test.
Download a free ten point 1031 Exchange Checklist here to understand relevant exchange issues.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
