Section 1031 requires that both the relinquished and the replacement properties be “held for productive use in a trade or business or for investment.” The question about whether a property qualifies for 1031 treatment arises when a property that may be a rental is also used as a vacation home from time to time.

IRS Rev Proc. 2008-16 creates a safe harbor for taxpayers where they will not be challenged on whether a property qualifies as property held for productive use in a trade or business or for investment. The standards in section 4.02 of the revenue procedure must be met.

(1) Relinquished property. A dwelling unit that a taxpayer intends to be relinquished property in a Section 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the “qualifying use period”); and

(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange;

(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more; and

(ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

(2) Replacement property. A dwelling unit that a taxpayer intends to be replacement property in a Section 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and

(b) Within the qualifying use period, in each of the two 12-month periods immediately after the exchange;

(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more; and

(ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

(For purposes of this revenue procedure, whether a dwelling unit is rented at a fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the parties to the rental agreement are taken into account.)

Let’s assume that a property has earned no rentals, and was used for vacation use. Could it still be considered a property eligible for a 1031 exchange?

In 2004, the United States Tax Court, the highest ranking tax court, issued a summary opinion, Rivera v. Commissioner, which addresses the issue of whether a vacation property can be an “investment” property. The case did not deal with a 1031 exchange, but rather addressed deductions made on investment property. The case involved a vacation home in Lake Tahoe.

The owners did rent the property out from time to time and testified that they did not violate the 14-day or 10% rule. The key testimony cited by the court was that the taxpayer purchased the property with the intention that it was an investment property. The fact that the property did not earn a profit or even have substantial rentals did not change the courts decision that the property was indeed held as an “investment”. The clearer the intent to hold the property as an investment, at the time of purchase and thereafter, the greater the chance of avoiding scrutiny by the Service.

There are five issues that should be considered in determining whether a taxpayer will be successful in defending an audit of a 1031 exchange on a property that was used, to some extent, for personal vacation use.

5 Issues

1. Rental Income. Did the property have a valid amount of rental income?

 

2. Was the property ever listed for rent without unreasonable restrictions that would limit the available pool of potential renters?

 

3. Was the property listed for Fair Market Value?

 

4. Did the Taxpayer claim this property as an investment property on their past income tax returns?

 

5. Did the Taxpayer use the property for personal use for more than 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

The Vacation Home Issue – Capital 1031 Exchange Company