Ruling lays ground work for 1031s and vacation homes

Real Estate Weekly, July 20, 2005 by Gary Gorman

Whether vacation, or "second", homes qualify for 1031 exchanges is a hotly contested issue within the 1031 exchange community. Every 1031 intermediary seems to have an opinion, few of which are based upon an understanding of tax law, or 1031 law. Most CPA's and tax attorneys also have an opinion, but few of them have a background in 1031 law, or adequate access to 1031 cases and rulings. What is the correct answer?

Section 1031 rolls the gain from the sale of "investment" property over to replacement investment property. The question is whether a vacation home constitutes investment property. Obviously if you rented your vacation home to others, or at least tried to do so, you've held it for investment. But what if you've never rented it? What if you've only used it personally?

We have two sources of guidance for the application of Section 1031 to vacation homes--a letter ruling and a tax court case. In 1981 the IRS issued a Letter Ruling (Ltr Rul 8103117) that allowed a 1031 exchange on a vacation home that was sold and replaced with another vacation home. The Old Vacation Home that was sold had not been rented for the six or seven years prior to the exchange, and had been held for both "personal enjoyment" and as a "sound real estate investment". The New Vacation Home that was purchased was also intended to be held for the same personal enjoyment and investment intent.

In this letter ruling, it seems clear that the service relied upon the fact that part of the taxpayer's intent was to hold the property as an investment, although you might conclude that this motivation was secondary to their desire to own the property for personal enjoyment (because each time it mentioned the reasons for owning the property, enjoyment was always mentioned as the first reason).

A common question we hear is: "Does the amount of usage of the property affect its status as investment property?" In the letter ruling the taxpayer's had minimal usage of the property in the few years before they sold it. The IRS only mentions this in it's recital of the facts, and then never mentions it again. Some argued the fact that they mentioned it makes it an important consideration, while some (including me) argue that if the IRS mentions it once it is background; if they mention it twice or more it is an important fact that they relied upon for their ruling.

The second source of guidance is a recent U.S. Tax Court case (Rivera v. Commissioner). This case is significant because the U.S. Tax Court is the Supreme Court, if you will, of tax law, so the weight of this decision is heavy. (Although that being said, this is a Summary Opinion and carries only persuasive support--albeit a strong one--and not the actual precedence of law ...)

The property involved in this case is a vacation home near the Lake Tahoe ski and vacation area of Truckee, California. The property had very little rental activity in the two years of the case, as well as the five or six prior years, and most of the days the property was used were personal days of the owners and rental activity was minimal.

While the issues in the case do not involve Section 1031 directly, the question of whether or not the property was investment property was addressed by the Court. The court determined that the property was held primarily for investment purposes based solely upon the testimony of Mrs. Rivera that she and her husband purchased the property with the "expectation that it would increase in value".

So the Rivera case seems to confirm the IRS's previous letter ruling: a vacation home is investment property (and available for a 1031 exchange) if you have some expectation that it will appreciate in value. Proof of your expectation is apparently as simple as saying it is so, and personal usage does not appear to be a factor.

Having said that, we still recommend to our clients, that if they are not going to rent the property, that they take some action to document their investment intent. This can be as simple as writing a letter to their CPA or attorney stating that they intend to hold the property as an investment, and for future appreciation.

Gary Gorman, is a retired CPA and author of the 1031 book "'Exchanging Up!"