“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.
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.
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 up at www.DST.investments or email us at support@dst.investments.