IRS grants 1031 safe harbor to vacation homes

Real Estate Weekly, March 12, 2008 by Pamela A. Michaels

At long last, the IRS has issued a Revenue Procedure which provides a "safe harbor" to taxpayers seeking to perform a [Section] 1031 exchange with real property held primarily for investment but partially used by the taxpayer for personal enjoyment.

First, lets examine the history of [Section] 1031 as it relates to vacation homes. Second, lets discuss why the issuance of this new Revenue Procedure (Revenue Procedure 2008-16) is so remarkable and helpful to taxpayers.

From the enactment of [Section] 1031 in 1921, per the express terms of the statute, a taxpayer must substantiate that both the relinquished property and the replacement property have been "held for investment or for productive use in a trade or business".

The meaning of these terms is too lengthy of a discussion for this article and the subject of other articles. However, generally speaking, the IRS considers several factors in determining whether the "held for investment' standard has been met.

These factors include the intent of the taxpayer, the length of time of ownership, whether income producing activities have occurred with respect to the property, the extent of the improvments made to the property by the taxpayer, the extent and timing of resale activities with respect to the property and whether the taxpayer has evidence that his or her primary motive for holding the property is for investment and not for personal enjoyment.

This final standard was the determining factor in the recent case of Barry E. Moore v. Commissioner, T.C. Memo 2007-134, which shed considerable light on the tax court's view of what a taxpayer must substantiate to evidence that property is held primarily for investment.

Therein the court held that the mere fact that a taxpayer believes a property might appreciate in value is not sufficient to establish investment intent when the property has been used solely for the personal enjoyment of the taxpayer and the taxpayer's family.

In Moore, the tax court noted that the taxpayer had never even attempted to rent out either of the vacation properties, had taken only home mortgage interest deductions and no investment deductions and had let the property fall into disrepair when their personal use of the property ceased.

As a result of this ruling, it was further confirmed that a property used entirely by a taxpayer for personal enjoyment would not qualify for use in a [Section] 1031 exchange. However, although the case indicated why the tax court concluded the taxpayer's primary motive in the case to be personal enjoyment, it did not address what a taxpayer specifically needed to do to enable the taxpayer to substantiate that a property partially used for personal enjoyment has nevertheless been held primarily for investment purposes.

The enactment of Revenue Procedure 2008-16 answers this question succcintly. The Revenue Procedure is remarkable in that it provides taxpayers with an absolute guarantee that, provided the taxpayer complies with the Revenue Procedure, he or she will have established that the property at issue in fact was "held for investment".

The Revenue Procedure sets forth factual circumstances which must be adhered to by the taxpayer to take advantage of the safe harbor provision. Specifically, the taxpayer must establish both with respect to the relinquished and replacement property, the following:

The properties have been owned by the taxpayer for 24 months minimum prior to and after the exchange (the "Qualifying Period");

During each 12 month periods of the Qualifying Period, the property has been rented at fair value to another person for a minimum of 14 days; and

The taxpayer's personal use of the property during each 12 month period does not exceed the greater of 14 days or 10% of the time rented at fair value.

Personal use of a dwelling unit is deemed to occur under the Revenue Procedure on any day in which the taxpayer uses the property for personal purposes under [Section]280A(d)(2) (taking into account [Section]280A(d)(3) but not [Section]280A(d)(4)).

Thus, personal use includes: (1) use by the taxpayer or any other person who has an interest in the property or by a family member; (2) use by any individual who uses the property under an arrangement that provides the taxpayer with some use of another dwelling, whether or not rent is charged for the use of the other dwelling; or (3) use by any other individual if rented for less than fair market value. A taxpayer can rent the property to a family member if the family member uses the property as a primary residence and the family member pays fair market rent.

Further, whether a dwelling unit is rented at a fair market rent is determined based on all the facts and circumstances that exist when the rental agreement is entered into and taking into account all rights and obligations of the parties to the rental agreement.

Finally, the Revenue Procedure states that it applies only to exchanges occurring after March 10, 2008.

A couple of comments about the effect of the above on taxpayers who perform exchanges on vacation homes. First, for those performing exchanges on vacation property after the effective date of the Revenue Procedure and who comply with its requirements, the taxpayer will be in good standing regarding the property qualifying as being held for investment.