The communities surrounding Lake Tahoe, and to a lesser extent, those of western Nevada, have always been popular areas for vacation home ownership. Historically, there has been ambiguity as to whether or not a vacation home qualifies for an IRC Section 1031 tax deferred exchange. This article will address recent developments surrounding vacation home exchanges, and specifically a new Revenue Procedure provided by the IRS. Property owners, real estate agents and their tax advisors should review this new revenue procedure and may want to take advantage of the safe harbor treatment provided by it.
In IRC Section 1031, property held for productive use in a trade, business, or held for investment may be exchanged for other property of like-kind which is to be held for productive use in a trade, business, or held for investment. Beyond this basic requirement are little specific criteria applicable to vacation homes as to when these conditions were met. Taxpayers and their tax advisors who felt they could substantiate property was held primarily for investment often chose to take advantage of tax deferral under Section 1031 on the disposition of a vacation property.
The recent case of Barry E. Moore v. Commissioner, T.C. Memo 2007-134, shed considerable light on the tax court's view of what a taxpayer must substantiate to show property was held primarily for investment. Therein the court held that the mere fact that a taxpayer believes a property might appreciate in value is not sufficient to establish invest-ment intent, especially when the property was used solely for the personal enjoyment of the taxpayer and the taxpayer's family.
In Moore, the tax court noted that the taxpayer had never even attempted to rent the property. However, although the case indicated why it concluded that the taxpayer's primary motive in the case was personal enjoyment, the case did not address what a taxpayer specifically needed to do to enable the taxpayer to substantiate that a property partially used for personal enjoyment has been also held primarily for investment purposes. This leads us to the very recent and aforementioned Revenue Procedure.
Revenue Procedure 2008-16 creates a safe-harbor definition of investment property applicable to exchange transactions closing after March 10, 2008 that involve the transfer of property consisting of a dwelling unit and/or the acquisition of a dwelling unit as replacement property. In short, the IRS will not challenge whether a residential property or vacation home property is held for productive use in a trade or business or for investment if certain specified ownership and use requirements are met. This safe harbor procedure provides useful guidance on the characterization of vacation property and may also be useful for planning purposes such as the conversion of a principal residence into a qualifying relinquished property.
A dwelling unit is defined as any real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations includ-ing a sleeping space, bathroom and cooking facilities (e.g., a residential property).
The IRS will not challenge whether a dwelling unit qualifies as Section 1031 exchange property held for productive use in a trade or business or for investment if: 1. the relinquished property is owned by the taxpayer for at least 24 months immediately prior to the exchange and a replacement property is owned for at least 24 months immediately after the exchange (the "qualifying use period") and 2. within each of the two 12-month periods constituting the qualifying use period, the taxpayer must rent the property to another person or persons at a fair rental for 14 or more days; and he 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 the dwelling unit is rented at a fair rental.
Under the procedure, personal use of a dwelling unit includes: use by the taxpayer or any other person who has an interest in the property or by a family member; use by any individual who uses the unit under an arrangement which enables the taxpayer to use some other dwelling unit (whether or not a rental is charged for the use of such other unit); or use by any other individual if rented for less than fair market value. A taxpayer can rent the property to a family member if the family member uses the property as a primary residence and the family member pays fair market rent. Whether a dwelling unit is rented at a fair rental is determined based on all 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.
The procedure provides a safe harbor for purposes of characterizing investment property for purposes of Internal Revenue Code Section 1031. Property that does not meet the terms of the safe harbor may nevertheless constitute qualifying relinquished or replacement property under current law. Of course, any exchange must meet all other applicable legal requirements. Every taxpayer should consult with their legal and tax advisor before engaging in any Section 1031 exchange.
Craig Chagnon is the Nevada and Utah division manager with Asset Preservation Inc., a qualified intermediary for Section 1031 exchange. Contact him at 1-800-282-1031 or craig@apiexchange.com. This information is not intended to replace qualified legal and/or tax advisors. Taxpayers should review their specific transactions with their own legal and/or tax counsel.
