Vacation Homes and IRC Section 1031 Exchanges

Back in Feb­ru­ary of 2008, the IRS estab­lished guide­lines for deter­min­ing whether a vaca­tion home qual­i­fies for a 1031 Exchange. Although exchanges of sec­ond homes have been done for years, we now have the defin­i­tive abil­i­ty to con­firm, yes they can qual­i­fy.

“Sec­ond homes” or Vaca­tion Homes” offer anoth­er oppor­tu­ni­ty for the 1031 Exchange. Often a taxpayer’s best invest­ment has been his vaca­tion home and yet many tax and legal experts have argued against sec­tion 1031 when it came time to sell.

Revenue Procedure 2008–16 sets forth the safe harbor guidelines as follows: 

RELINQUISHED PROPERTY

• The hold­ing peri­od for the vaca­tion home is at least 24 months imme­di­ate­ly before the exchange;
• For each of the two 12-month peri­ods, the vaca­tion home is rent­ed to anoth­er per­son at a fair rental for 14 days or more; and
• The home­own­er lim­its his use of the vaca­tion home to not more than 14 days or 10% of the num­ber of days dur­ing the 12-month peri­od that the vaca­tion home is rent­ed at a fair rental val­ue.

REPLACEMENT PROPERTY

• The hold­ing peri­od fol­low­ing the exchange is at least 24 months;
• For each of the two 12-month peri­ods, the vaca­tion home is rent­ed to anoth­er per­son at a fair rental for 14 days or more; and
• The home­own­er lim­its his use of the vaca­tion home to not more than 14 days or 10% of the num­ber of days dur­ing the 12-month peri­od that the vaca­tion home is rent­ed at a fair rental val­ue.

When con­tem­plat­ing an exchange, one of the most com­mon ques­tions real estate investors ask is: Will my mixed-use vaca­tion prop­er­ty be eli­gi­ble for an exchange? Thank­ful­ly, the answer to this ques­tion is “yes.”

Instead, like oth­er rev­enue pro­ce­dures issued by the IRS, is a guide­line intend­ed to sup­ple­ment the agency’s inter­pre­ta­tion of Sec­tion 1031. If tax­pay­ers fol­low this pro­ce­dure, the IRS will not chal­lenge the vaca­tion home’s eli­gi­bil­i­ty as relin­quished prop­er­ty. Abid­ing by this doc­u­ment will mean avoid­ing a legal chal­lenge, but this doesn’t mean going out­side the bounds of 2008–16 will nec­es­sar­i­ly result in a failed trans­ac­tion.

What Rev. Proc. 2008–16 is say­ing is that the IRS will not chal­lenge the “hold­ing require­ment” of Sec­tion 1031 if tax­pay­ers fol­low its guide­lines. The poten­tial issue that could be pre­sent­ed by vaca­tion homes is the hold­ing require­ment. That is, there could be a dis­pute over whether such prop­er­ty sat­is­fies the require­ment that relin­quished prop­er­ty must be “held for” invest­ment.

If tax­pay­ers dis­obey Rev. Proc. 2008–16, the hold­ing require­ment may still be met, but the issue can only be resolved on a case-by-case basis. It is not a quan­ti­ta­tive require­ment, as we know, but a qual­i­ta­tive one, and it demands an indi­vid­u­al­ized analy­sis by the court. The lan­guage and appear­ance of the pro­ce­dure may seem author­i­ta­tive, but accoun­tants should be aware that it is not a set of strict rules.

Despite the con­fu­sion the above may seem to cause, the guide­lines are straight­for­ward: For vaca­tion homes used as relin­quished prop­er­ty, tax­pay­ers should own the prop­er­ty for at least 24 months pri­or to the exchange. For replace­ment prop­er­ty to be used as a vaca­tion home, it should also be held for a min­i­mum of 24 months.

These own­er­ship peri­ods are referred to as “qual­i­fy­ing use” peri­ods, which oper­ate just before the exchange (for relin­quished prop­er­ty) or just after it (for replace­ment prop­er­ty). In oth­er words, if a tax­pay­er owns a relin­quished prop­er­ty vaca­tion home for five years, only the 24 months imme­di­ate­ly pre­ced­ing the exchange con­sti­tute the qual­i­fy­ing use peri­od.

Tax­pay­ers must rent the home at a fair mar­ket val­ue for at least 14 days in each of the two 12-month time seg­ments which make up the 24-month qual­i­fy­ing use peri­od. Also, their per­son­al use of the home can­not exceed the greater of 14 days or 10 per­cent of the total days the home is used as a rental dur­ing each 12-month seg­ment. These guide­lines apply to both relin­quished and replace­ment prop­er­ty. Thus, the IRS is mak­ing it clear that the hold­ing require­ment will not be con­test­ed should these guide­lines be observed.

DST Invest­ments is a reg­is­tered invest­ment advi­sor that spe­cial­izes in DST 1031 Con­sult­ing ser­vices. For a com­pli­men­ta­ry con­sul­ta­tion, please vis­it us at www.DST.investments or email us at support@dst.investments.