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Are You Spending Too Much Time At
Your Vacation Home?
The IRS May Think So
Introduction
A vacation home can be a great getaway, a wonderful investment and even a source of income. While a vacation home can provide many benefits, when it comes time to trade in the beach house for a cabin in the mountains, the owner may be faced with paying taxes on the gain from the sale. When a taxpayer sells his or her personal residence, if certain requirements are met, the taxpayer can exclude part or all of the gain from the sale. A similar benefit is not available for the sale of vacation homes.
However, it can be possible to exchange one vacation home for another and avoid recognizing any gain until the sale of the new vacation home. This non-recognition treatment can be achieved if the exchange of the vacation homes qualifies as a like-kind exchange under Section 1031 of the tax law(a 1031 Exchange). Beginning with exchanges that occur on or after March 10, 2008, the IRS will follow a new safe harbor rule for determining when the exchange of vacation homes qualifies as a 1031 Exchange.
1031 Exchange Requirements
To understand the new safe harbor rule, you need to understand the basic requirements of a 1031 Exchange. There are three basic requirements that must be satisfied for an exchange of property to qualify as a 1031 Exchange.
1. The properties must be of a like-kind. Real estate exchanged for real estate qualifies, while real estate exchanged for other property, like a tractor, would not.
2. The taxpayer does not receive cash. If the taxpayer receives or takes control of cash during the transaction, the exchange can still qualify for non-recognition, but the taxpayer must recognize gain to the extent cash is received. Generally an exchange accommodator is used to ensure that the taxpayer does not inadvertently take control of cash that would require recognition of gain.
3. The property given up and the property received must be either (a) property held for productive use in a trade or business, or (b) held for investment. As a practical matter, a vacation home needs to fit into the second category and be considered held for investment for an exchange to qualify as a 1031 Exchange.
The New Safe Harbor Rule
Owning a vacation home with a mere hope or expectation that it will later be sold for a gain does not show that it is held for investment. Additionally, courts have ruled that if property is used exclusively as a personal residence, it cannot be considered as "held for investment" for purposes of satisfying the 1031 Exchange requirements. The taxpayer must show that the vacation home is held for investment and not used exclusively by the taxpayer as a personal residence. This can be done by renting the vacation home out. The new safe harbor rule specifies the minimum amount of time a vacation home needs to be rented out and the maximum amount of time it can be used for the personal use of the owner for it to qualify as held for investment.
As mentioned above, to qualify as held for investment, the vacation homes that are exchanged must satisfy a minimum rental use and maximum personal use for a specified term. The specified term for the vacation home given up in the exchange is the two 12-month periods immediately before the exchange. Likewise, the specified term for the vacation home that is received is the two 12-month periods immediately after the exchange. The minimum rental use and maximum personal use are:
1. Minimum Rental Use. The taxpayer rents the vacation home to another person for 14 days or more during each 12-month period in the specified term before the exchanged (for the home given up) and in the specified term after the exchange (for the home received). The taxpayer must rent the vacation homes for fair rent, based on all the facts and circumstances, for the use to count toward the minimum rental use of the property.
2. Maximum Personal Use. The taxpayer's personal use of the vacation home for each 12-month period in each specified term cannot exceed the greater of: (a) 14 days, or (b) 10% of the number of days during the 12-month period when the home was rented to another person at fair rent.
This safe harbor rule and the minimum rental use requirement it includes does not change the existing tax rules on when vacation rental expenses can be deducted. The safe harbor rule only affects the classification of the vacation home as held for investment for 1031 Exchange purposes.
Conclusion
If you own a vacation home and are thinking of exchanging it for another, this new IRS safe harbor could prove very useful. Satisfying the safe harbor rules requires a four year commitment to satisfying the minimum rental use and maximum personal use requirements. While restricting your personal use of your vacation home may prove difficult, the benefits of 1031 Exchange treatment may be well worth it.
If you have any questions, please contact the author of the foregoing, Melissa Busley or Bob Winger, head of the Dunn Carney Tax Team.
Any tax advice contained herein, or in any attachment, is not a covered opinion under Circular 230 and therefore cannot be used, by itself, for the purpose of avoiding tax penalties that may be imposed. If you would like to receive a covered opinion or advice regarding the nature or possible extent of tax penalties, please let us know.
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