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Internal Revenue Code Section 1031 allows for the tax-deferred exchange of real property
that is held for investment. Perhaps no exchange issue is more controversial than the question
of what constitutes an investment. Vacation homes or 2nd homes sometimes will qualify for a
1031 Exchange. However, such qualification depends on the circumstances of property use.
In analyzing whether a vacation home qualifies as an investment for 1031 Exchange purposes,
it is perhaps best to categorize the uses of the property into three separate categories. First,
the home is used exclusively for personal reasons without any rental activity. Second, the
home is used exclusively as a rental without any personal use. Third, the home is used both personally and as a rental.When a home is used exclusively for personal, non-rental purposes
it is well established that the property does not qualify for tax-deferred exchange treatment. Conversely, if a home is used exclusively for rental purposes, the property almost certainly
qualifies as an investment that can be exchanged. The third category, mixed personal and
rental use, requires the most analysis and is the least clear when determining exchange qualification.Current exchange tax law does not provide a clear test for determining whether
a mixed-use property qualifies for exchange treatment. Many tax attorneys have looked to
other sections of the internal revenue code for guidance. IRC Section 280A provides that a
taxpayer cannot deduct losses or mortgage interest on properties that were personally used
by the taxpayer for more than 14 days or 10% of the days the property was rented,
whichever is more. Using this standard, if a property is rented out for less than 140 days per
year, the taxpayer should not use the property personally for more than 14 days per year.
However, if personal use is 14 days or less, exchange qualification is not assured. Although
there is no definitive guidance, the following guidelines can be informative when determining
whether a property qualifies for exchange treatment.
- Personal use is more than 14 days: Exchange qualification is unlikely unless rental
- activity is more than 140 days per year.
- Personal use is 14 days or less but rental days less than personal use days. Exchange qualification is again unlikely but more likely than scenario 1.
- Personal use is 14 days or less and rental days are more than personal use days.
- Exchange qualification is more likely although not assured. Whenever real property is
- used for personal purposes, exchange treatment is not assured.
Along with the unofficial guidelines listed above, rental should be reported on tax returns,
along with depreciation. Failure to report income and depreciation will cloud any claim of
investment motivation and exchange treatment. In addition, property rentals should be at or
within fair market rent range to help further establish income motivation. For example, renting
a property to your son or neighbor for $10 per night is not good evidence that your primary motivation for owning the property was rental income and capital appreciation.
When a property has both personal use and rental use, a definitive answer as to exchange qualification is unfortunately not possible. The individual facts and circumstances should be
closely examined. The more rental activity and the less personal use, the more likely the
property is to qualify for tax-deferred exchange treatment.
Please note that all 1031 Exchanges should be planned with the assistance of experienced tax
counsel. This is especially true for complicated exchanges involving business entities as
described in this article. This article has attempted to briefly survey the issue discussed and
does not portend to be an all-inclusive analysis of the subject matter.
By Adam Skarsgard, Esq, CPA
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