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 40 percent of the net sales price. The Internal Revenue Service (IRS) Section of the tax code is used by taxpayers who own real property, such as vacation and commercial property, 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 or full tax is due. The 1031 tax code also applies to property held internationally when replaced with property held overseas. Many investors who are looking to defer taxes on the sale of their vacation home or rental property find that a 1031 exchange can be a powerful tool.
Vacation Property and Personal Use
Often when a vacation property is acquired, held as a rental and sold, capital gain taxes are deferred in a 1031 exchange. Effective March 10, 2008, Revenue Procedure 2008-16 provides a safe harbor that states, if the requirements are satisfied, the IRS will not challenge whether the vacation home qualifies for a 1031 exchange as property held for productive use in a business or for investment. The Revenue Procedure requires vacation property to be rented at least 14 overnights for each of two years preceding the 1031 exchange. Personal use must not be greater than 14 overnights in each of the two years or 10 percent of the number of days the property is rented at fair market rental per year.
Renting to family members to satisfy the 14 rental overnights is 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 14 night personal use threshold. If a vacation home is acquired as the replacement property in a 1031 exchange, the 14 nights in two years rental requirement and personal use limitation is in effect.
Personal Use Exceeds 14 Overnights
What if personal use exceeds 14 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 14 overnights and renting the property at least the 14 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 14 rental nights and limited personal use of 14 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.
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.
Related Party Use
Related party use counts towards taxpayer’s use, including taxpayer’s family, brothers and sisters, spouse and lineal descendants as referenced by Internal Revenue Code Section 267(c)(4). Aunts, uncles, nephews, nieces, in-laws, stepparents or domestic partners are not considered related parties. According to Section 280A(d)(3), the vacation property can be rented as a primary residence to the taxpayer’s child or other family member at fair market rent. The primary residence rental qualifies for the 14-day minimum requirement.
If you are considering a 1031 exchange for your vacation home or rental property, Atlas 1031 provides the accommodation services compliant with Internal Revenue Code Section 1031. Click below to begin a consultation or call our office at 1 800 227 1031.
