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from Feb 2008 issue of Houston Real Estate Experts - FREE subscription

Finally — IRS Guidance on Exchanging Vacation Homes

by Alan Hall

Until now, the issue of whether a vacation home qualifies for tax deferral treatment under the "1031 exchange" rules (IRC §1031) was the subject of much scrutiny and uncertainty. To the delight of many tax practitioners, on February 15, 2008, the IRS eliminated that uncertainty by issuing Revenue Procedure ("Rev. Proc.") 2008-16, effective March 10, 2008, which provides a safe harbor for exchanges of vacation homes (defined as "dwelling unit" in the Rev. Proc.). Now taxpayers can have a clear understanding of the circumstances under which the IRS will not challenge whether a vacation home will qualify as property "held for investment" under §1031.

Vacation Home as Relinquished Property

For a vacation home to qualify as relinquished property, it must meet the following criteria:

• It is owned by the taxpayer for at least 24 months immediately before the exchange ("qualifying use period"); and
• Within the qualifying use period, in each of the two 12 month periods,

1. the taxpayer rents the dwelling unit at fair rental to another person for 14 days or more and
2. the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12 month period that the dwelling unit was rented at fair rental value.

The 12 month period immediately after the exchange begins on the day after the exchange takes place, and the second 12 month period begins on the day after the first 12 month period ends.

Personal use is defined broadly

Use by the taxpayer or other person having an interest in the dwelling unit and any family member (brothers and sisters by the whole or half blood, spouses, ancestors, and lineal descendants) will be considered "personal use" by the taxpayer. Also, any arrangement whereby fair market rent is not paid will be considered "personal use" by the taxpayer. Notwithstanding the foregoing, use by family members will not be considered "personal use" by the taxpayer only if the dwelling unit is rented at fair market rent and the family member uses it as his principal residence.

Fair rental is based upon all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the rental agreement are taken into account.

Note special rule for replacement property

If the taxpayer files a return reporting a transaction under §1031 based on the expectation that the dwelling unit will meet the qualifying use standards and subsequently determines that the dwelling unit does not meet the qualifying use standards, the taxpayer, if necessary, should file an amended return.

Exchanges of vacation homes outside the Rev. Proc. 2008-16 safe harbor

An exchange of a vacation home may still qualify under §1031 even though it falls outside the parameters of Rev. Proc. 2008-16. Any such circumstance will be subject to greater scrutiny and therefore should be carefully planned and reviewed by the taxpayer’s tax advisor.

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Alan Hall, 1031 exchange facilitator

As a Qualified Intermediary for like-kind property exchanges (aka 1031 exchanges), Alan Hall manages Texas, Oklahoma, New Mexico, Louisiana, and Missouri for Old Republic Exchange Company. He is an accomplished real estate broker and investor and is a frequent speaker on all aspects of tax deferred 1031 Exchanges. Alan can be reached at (866) 622-1031 or by email.