Vacation Home 1031 Exchanges

Section 1031 of the Internal Revenue Code ("IRC") permits owners of "like kind" properties to trade their holdings and, by doing so, to defer until a future date all or a portion of their capital gains tax obligations on the profits. Real estate held as an investment is considered to be "like kind" and qualifies for a 1031 exchange when traded for another piece of real estate held for investment. "Investment" in this case simply means that the main motive for ownership is the anticipated appreciation in value. A principal residence doesn't qualify for an exchange under Section 1031. As the terms are used in the discussion that follows, a "relinquished property" is one given up in an exchange, and a "replacement property" is one acquired in an exchange.

Vacation Home Classifications

The IRC defines a "vacation home" as a single dwelling unit in addition to the owner's principal residence, and further defines a "single dwelling unit" as one having sleeping, bathroom and cooking facilities. The owner of a vacation home may decide to occupy it exclusively or to rent it to other persons for all or a portion of a calendar year. Mortgage interest and property taxes are generally deductible. However, the IRC's requirements for reporting rental income and determining the deductibility of expenses for a given calendar year are based on the number of days the home is rented as compared to the number of days the owner occupies it for personal use. As a result, a vacation home can have one of three use classifications.

Classification-1 Vacation Home.
The IRC considers this to be a personal-use property. This is a home that's rented for 14 days or less during the tax year. The owner doesn't have to report the rental income, but cannot deduct any other expenses besides mortgage interest and property taxes.

Classification-2 Vacation Home.
The IRC considers this to be a mixed personal-use and rental-use property. This is a home that's rented for more than 14 days during the tax year, but also occupied by the owner for more than 14 days or 10% of rental days, whichever is greater. The owner must report the rental income and may deduct expenses, such as insurance and utilities, but only the portions that are allocated to rental-use days.

Classification-3 Vacation Home.
The IRC considers this to be a rental-use property. This is a home that's rented for more than 14 days during the tax year, and occupied by the owner for 14 or less days or 10% of rental days, whichever is greater. As with a Classification-2 Vacation Home, the owner must report the rental income and may deduct expenses, but once again only the portions that are allocated to rental-use days.

Safe Harbor Exchange Procedure

There's been a great deal of confusion as to whether a vacation home qualifies for a 1031 exchange, particularly when the owner has occasionally used the property for personal purposes. Is it an investment property because it was rented to others? If so, it should qualify. Is it a personal-use property because the owner occasionally occupied it? If so, it may not qualify. To clear up the confusion, the Internal Revenue Service (IRS) in March 2008 issued Revenue Procedure 2008-16 ("Procedure"), which establishes a "safe harbor" procedure under which a vacation home will be considered an "investment property" and, therefore, eligible for a 1031 exchange. The term, "safe harbor," simply means that the IRS won't challenge an exchange satisfying this Procedure, provided that it satisfies all other requirements for a like-kind exchange under Section 1031. The Procedure became effective for exchanges of vacation homes occurring on or after March 10, 2008. From the summary that follows, it's obvious that only Classification-3 Vacation Homes will qualify.

Relinquished Property. A relinquished property qualifies as an investment property and is eligible for an exchange if:

* The owner owned it for at least 24 months immediately prior to the exchange.
* The owner has rented the property to another person or persons at fair value for 14 days or more during each of the two 12-month periods immediately prior to the exchange.
* The owner's personal use of the property hasn't exceeded the greater of 14 days or 10% of rental days during each of the two 12-month periods immediately prior to the exchange.

Replacement Property. The requirements for a replacement property are identical to those for the relinquished property. The replacement property qualifies if:

* The owner owns it for at least 24 months immediately following the exchange.
* The owner rents the property to another person or persons at fair value for 14 days or more in each of the two 12-month periods immediately following the exchange.
* The owner's personal use of the property doesn't exceed the greater of 14 days or 10% of rental days in each of the two 12-month periods immediately following the exchange.

This Blog is not intended to be legal or tax advice and readers of this Blog should consult their own lawyer or tax preparer for legal or tax advice, as applicable.