Your Vacation Home and the 1031 Exchange

Consider the following.

You own a lakeside vacation home. Over the years, that home has been a great place for family gatherings, and to hang out on weekends. Now, the family is grown and you are ready to dispose of the property, hopefully without paying a boatload of capital gain taxes.

So, here is a question: Would relinquishing your house through a 1031 Exchange qualify for tax-deferral treatment?

The answer is: It depends.

Revisiting the 1031 Exchange

If you’ve read our previous blogs, you know that an asset qualifies for tax-deferral treatment via the Internal Revenue Code (IRC) 1031, provided the relinquished property is “held for productive use in a trade or business, or for investment.” And, you know that the asset needs to be exchanged for a like-kind property.

So, the quick answer to the above question about your house might be no. Unless you are renting the property out, or using it as a place of business, any tax deferral treatment upon relinquishment could be slim to none. The not-so-quick answer, however, is there are gray areas in the exchange rules.

Contradictions: A History of Exchange

The primary issue the Internal Revenue Services (IRS) has been trying to address is when/if a vacation property or secondary residence could be considered “qualified use property,” and eligible for 1031 Exchange treatment.

The first attempt to address the issue was when the IRS issued Private Letter Ruling (PLR) 1981-03117 in 1981. The PLR stated that vacation properties and secondary residences could qualify for exchanges, as long as the relinquished property was held for investment, as well as personal enjoyment.

Then came 1991, and the Department of the Treasury’s Deferred Exchange Regulations, with the mandate that assets held for investment or business use were eligible for exchange and tax deferred treatment. What did not fall into this category, however, were secondary residences and vacation properties – unless those assets were rentals, investments, or used for business.

The United States Tax Court added to the situation with its Tax Court Memorandum 2007-134, issued in 2007. The focus here was intent; deferral treatment could be considered, if the investor’s intent, at the time of the exchange, was that the property was held for investment and enjoyment.

Finally, the IRS issued Revenue Procedure 2008-16 in 2008, providing a safe harbor on how, exactly, residences might qualify for the exchange treatment.

Investment? Or Rental?

The safe harbor means the IRS likely won’t challenge the exchange treatment of your vacation home if:

• If the vacation home is being sold as part of your exchange, you own the relinquished residence for 24 months, ending the day before the exchange date, and
• If the vacation home is being acquired as part of your exchange, you own the replacement residence for 24 months beginning the day after the exchange date, and
• The residence is rented to someone else at a fair-market rate for at least 14 days within a given year, and
• You aren’t using the residence for more than 14 days or 10% of the days during which you might be renting it out to someone else

The IRC Code Section 280A(d) explains this further, noting that your vacation home could be considered a rental as long as your personal use is less than the greater of:

• 15 days
• 10% of the number of days in a year during which the property is rented to someone else at a fair-market value rate

Don’t want to rent it out? Then you might want to discontinue ALL personal use of the lake house for a year or more, and to report all property expenses as “investment-related expenses.”

In short, the answer to the question about exchanging your vacation home is yes, under certain circumstances. However, much like the 1031 Exchange process itself, there are specific rules to follow, to defer potential taxes.