IRS creates safe harbor for like-kind exchanges of vacation homes

Vacation homes have exploded in popularity in recent years with many individuals enjoying them for personal use and holding them for investment.  Traditionally, the IRS has had very strict rules about like-kind exchanges of vacation properties.  Like-kind exchange tax treatment under Internal Revenue Code Section 1031(a) is extremely valuable because, when one property is properly exchanged for another, appreciation on the first property escapes current tax and is deferred, sometimes almost indefinitely, until replacement property is sold.  As a result, the IRS has guarded use of like-kind exchange treatment to apply only to property largely used for rental or other businesses or investment property.

Especially in the case of vacation property, the government has closely guarded the like-kind exchange tax break by making sure that the owner of a property used as a personal or family retreat didn’t successfully argue that an occasional renter turned the retreat into business property. The problem in the past was that there was a very gray line drawn for vacation property owners to tell how much rental activity was enough to forestall an IRS challenge of the valuable right to like-kind exchange treatment.

Now, the IRS has issued guidance that gives vacation home owners a safe harbor for like-kind exchanges. The IRS will not challenge a vacation home as qualifying for purposes of Code Sec. 1031 as property held for productive use in a trade or business or for investment if the home is only occasionally used by the taxpayer for personal use and is predominately used to generate rental income. The IRS now clearly defines "occasional personal use" and "predominant rental use" as well as the period of time within which they must occur.

Safe harbor

The safe harbor criteria address both relinquished property and replacement property. For purposes of the safe harbor, the vacation home may be a house, condominium or similar dwelling that provides basic living accommodations including sleeping space, bathroom and cooking facilities.

Relinquished property.  A vacation property that a taxpayer intends to be relinquished property in a like-kind exchange qualifies if the dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange:

• The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
• The period of 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 is rented at a fair rental.

Replacement property. Likewise, a vacation property qualifies as replacement property if the dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and within the qualifying use period, in each of the two 12-month periods immediately after the exchange:

• The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
• The period of 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 is rented at a fair rental.

Personal use

The IRS also has explained the earmarks of a disqualifying “personal use” of either the relinquished or replacement property. While the 14 day or 10 percent rule mirrors Code Sec. 280A's test for a "residence" for rental expense deduction and rental income recognition purposes, the Code Sec. 280A test looks at each tax year, while the new Code Sec. 1031 safe harbor tests over each 12-month period immediately prior and after the exchange.

If you have any questions about like-kind exchanges of vacation properties, give our office a call.  We can help you decide if a like-kind exchange is the best approach along with exploring other options.

(Rev. Proc. 2008-16)