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Vacation Home Exchanges

New Guidance from the IRS

By

Michael S. Powlen
Global Law, LLP
© 2008 Michael Powlen.  All rights reserved.

            An important part of real estate investment is the ability to exchange out and into properties on a tax-deferred basis under Internal Revenue Code Section 1031.  Many investors trade up into new properties, change property types, change markets multiple times over many years without ever paying tax on the appreciation.  The companion provision to 1031 is Code Section 121, which allows homeowners to exclude gain up to $500,000 on the sale of a principal residence. 

            Second homes or vacation homes may fall into the gap between these two provisions, as second homes are not principal residences (so won’t qualify under Section 121) and may not qualify as investment property.  A requirement of Section 1031 is that property be held for investment or for productive use in a trade or business.  Courts have held that property that exclusively availed of for personal use does not qualify under Section 1031. 

            The IRS has recently issued Revenue Procedure 2008-16, which sets out safe harbor guidelines for like kind exchanges of vacation homes.  If a taxpayer follows these guidelines, then the IRS won’t challenge the exchange.  This Revenue Procedure provides that a dwelling unit qualifies under Section 1031 as property held for investment or held for productive use in a trade or business if:

(1) For the relinquished property:

(a) the dwelling 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 property at fair rent for at least 14 days or more, and

(ii) The taxpayer does not personally use the dwelling unit more than the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit was rented at a fair rental rate.

(2) For the replacement property:

(a) The dwelling unit is owned by the taxpayer for 24 months or more 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 it at fair rent for at least 14 days or more, and

(ii) The taxpayer does not personally use the property for more than the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit was rented. 

These rules are similar to the rules under Code Section 280A that govern when a taxpayer can take deductions on residences that are used as vacation or second homes. 

Bear in mind that the safe harbors in the Revenue Procedure are guidelines for when the IRS won’t challenge a transaction and not substantive statements of law.  A like kind exchange could still qualify even if it violated the safe harbor.  For example, if a taxpayer owned a vacation rental property for 18 months, rented it out at market rents for ten months a year and used it personally for one week a year, the property should clearly qualify for like kind exchange treatment even though the 24 month holding period in the Revenue Procedure is not met. 

While the Revenue Procedure leaves many grey areas, it does provide a safe harbor that may give many real estate investors peace of mind. 

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This entry was posted on Tuesday, May 6th, 2008 at 9:18 am and is filed under Real Estate Law. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.