We are often asked if the tax liability for the sale of a vacation home can be deferred using IRC section 1031 procedures. The answer to this question is found in the 2008-16 Revenue Procedure.
The general rule for ALL 1031 exchanges is that the property must be held primarily for investment or use in trade or business. To demonstrate that your vacation home is held primarily for investment, and therefore 1031-eligible, rather than for your personal use, the Internal Revenue Service (IRS) has established specific parameters that you must follow. This is known as a “safe port”. Those parameters are:
For the Leased or Old Vacation Property you must have:
You owned the property for at least two years, and;
In each of those two years, the property must have been rented for 14 days or more at fair market price.
For Replacement or New Vacation Ownership
You owned the property for at least two years, and;
In each of those two years, the property must have been rented for 14 days or more at fair market price.
In addition to these “safe harbor” requirements, there are additional requirements:
Your own use of 1031 exchange vacation homes must not exceed 14 nights or 10% of the rental days per year, whichever is less, but not including time spent at the property for repairs and maintenance.
The term “safe harbor” means that the IRS will not contest your 1031 tax deferral claim if you can prove these facts. The burden of proof always rests with the taxpayer. If you exchange 1031 vacation homes and cannot prove these precise facts, your 1031 exchange may still be honored. But it will be subject to increased scrutiny by the IRS. When you do not meet the “safe harbor” test, you can still prove investment intent by other facts and circumstances. Some of the best ways to demonstrate investment intent are:
Keep an analysis of the investment potential of the property when you buy it. Market trends and resale potential are important parts of this analysis,
List your vacation home on your tax return under Schedule E,
Take the depreciation
Show property income,
Keep track of your personal usage time, and remember that time spent on repair and maintenance is not counted as personal usage time.
Make improvements to the property that will maximize its investment potential,
Do not include the property on Schedule A of your tax return.
Showing why you sold the property in less than two years makes good investment sense.
Keep in mind that when planning ahead is possible, most taxpayers convert their vacation property for personal use to property held primarily for investment under the safe harbor rules above before doing a 1031 exchange. A Second Home it can be converted to an investment property, changing the character by placing the property in a rental pool, reducing personal use, and itemizing the property on Schedule E on the tax return.
Vacation properties held in a 1031 exchange can be converted to a primary home, in which case you may qualify for tax-exempt status under IRC section 121. A second home can be converted to an investment property, changing the character by placing the property in a rental pool, reducing personal use, and itemizing the property on Schedule E of the tax return.
All other requirements of section 1031 exchanges apply to vacation home exchanges.
By,
ESQ Steven Hickox