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New Rules Allowing A 1031 Exchange For Personal Use Of A Second Or Vacation Home

By James P Mcnamara - Under Revenue Procedure 2008-16, which went into effect March 10, a 1031 tax deferred exchange, which allows the owner of an investment property to roll over gains into another "like-kind" investment property, thereby, deferring the taxes on the gains, can now include personal vacation homes under certain circumstances. However, the personal use of a vacation home must officially be restricted, usually keeping personal use to less than 14 days per year or 10% of the time it is rented out to third parties. The property must be held for investment purposes with the expectation that it will appreciate in value.

Many "second or vacation homes" are actually investment properties because their owners rent them out a majority of the year. The IRS has steered clear of any personal use language regarding a tax-free exchange after a recent court case sparked a need for clarity.

Follow up:

In Moore vs. Commissioner, the taxpayers exchanged one Georgia lakeside vacation home for another. Neither home was rented and was used by the taxpayers only for personal purposes. The taxpayers claimed the exchange of the homes was a like-kind exchange under Section 1031, arguing that the market value appreciation was a valid justification for establishing a vacation home as an investment property.

The tax court held, however, the properties were held for personal use and that the "mere hope or expectation that property may be sold at a gain, cannot establish an investment intent if the taxpayer uses the property as a residence."

According to Section 1031 of the tax code, no gain or loss is recognized on the exchange of property held for productive use in a trade or business, or for investment, if the property is exchanged solely for property of like kind to be held either for productive use in a trade or business, or for investment. Heretofore, personal residences can't be exchanged tax-free under Section 1031 because they aren't held for productive use in a trade or business, or for investment.

Second or Vacation Homes

While the IRS is fully aware that many people use their investment properties for their own enjoyment, the Service is now saying that it will not challenge a 1031 exchange simply because there was personal use of an investment property. The acknowledgment that there can be personal use is a totally new position of the Service.

In light of the Moore case, the IRS has taken a more lenient approach to exchanges. While it now provides taxpayers with a safe harbor, they also gave us a direct check list under which a dwelling unit will qualify as property held for productive use in a trade or business, or for investment, for Section 1031 purposes, even though they will occasionally use it for personal purposes.

The IRS won't challenge whether a dwelling unit qualifies under Section 1031 as property held for productive use in a trade or business, or for investment, as long as other exchange rules are met.

Strict personal use rules of the investment property as a "second home" still apply. The Service adhered to the standard within IRC Section 280A for guidance. The period of the taxpayer's personal use of the dwelling unit cannot 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 market value.

The Moore case flunked the Section 1031 tax-free exchange test for a variety of reasons, according to the tax court. The taxpayers never rented or attempted to rent the properties. Nor did they offer the replacement property for sale until they were forced to do so by the need for liquidity, in connection with the division assets incident to their divorce. In addition, they failed to claim any tax deductions for maintenance expenses or depreciation connected with the properties and claimed interest deductions on both properties as home mortgage interest rather than as investment interest.

A tax adviser would recommend that, to establish that the property is investment property, a taxpayer should at a minimum, comply with the stated requirements regarding the deduction of losses, but also go beyond them by treating the property as investment property to the greatest extent possible. For example, keeping records for the property that are separate from the taxpayer's records for his personal residence may help establish the intent to hold the property as investment property rather than for personal use.

In the Moore case, the taxpayers hoped that both properties would appreciate. Instead the tax court found that the taxpayers' primary purpose in acquiring and holding the properties was to provide personal vacation retreats for their family.

Don't be afraid to use your beach house, ski lodge, or the French Quarter Par Terre, even though it's an investment property and you plan to exchange it for another investment property down the road. If you limit your personal use, you will be sailing into the IRS's new safe harbor.

Contact me and I will give you my thoughts on converting the property back to property held for investment purposes.

James P. McNamara is the Managing Principal of Exchange Equity, LLC. The Firm is a private real estate investment company that acts for its own account and for the account of co-investors in quality real estate properties that is headquartered in New Orleans, LA.

The Company created a Tenant In Common program to offer small and medium size investors, the opportunity to acquire the quality net-leased properties previously the exclusive purview of only the largest of institutional investors. The program is designed to accommodate the first time real estate investor looking to diversify their portfolio or for a passive investor looking to preserve and protect equity in a relinquished property exchange through an IRC §1031 Exchange.

For more information on the product, or to order online, visit http://www.exchangeequity.com or call 866-362-1031.

Media contact:

James P. McNamara
jamesp@exchangeequity.com

Phone: 504-897-1299

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