Using Vacation Homes in a Sec. 1031
In the past, we’ve discussed some issues that can arise in a tax-deferred Section 1031 like kind exchange. We’ve also covered the variations on the standard “delayed” exchange. We’ve seen that taxpayers may want to utilize certain, different, scenarios. One issue that comes up frequently with real estate investors in a 1031 exchange is the use of vacation homes. Specifically, the eligibility of vacation homes as relinquished property. This is an important issue. That’s because many real estate investors have vacation homes or “second homes”. Some of them are used to generate income. As with so many other aspects of Section 1031, vacation home eligibility follows specific IRS rules. As long as investors observe these rules, they’ll be able to use vacation homes in a Sec. 1031 exchange. They’ll also be able to do so without complication or fear of audit. Read on…
The relevant document is Revenue Procedure 2008-16. In this document, the IRS lays out the rules which determine the eligibility of “dwelling units”. It does so for dwellings not considered the primary residence of a taxpayer. In reality, Rev. Proc. 2008-16 is not actually a series of rules. Rather, it sets forth guidelines. If a taxpayer follows these guidelines, then his or her transaction (involving such a dwelling unit) will not be challenged. That is, at least not on the issue of the eligibility of the dwelling unit. If a taxpayer chooses not to follow these guidelines, then his or her transaction will enter a “gray area”. It may then be challenged by the IRS. In this post, we will discuss the guidelines of the Rev. Proc. in detail. We’ll then point out some of the unique advantages to using vacation homes in a Sec. 1031 exchange.
Revenue Procedure 2008-16
In order for a dwelling unit to qualify as an investment property within the meaning of the 1031 statute, a taxpayer must own the property for at least 24 months prior to selling it as part of an exchange. And, during each 12 month period leading up to the exchange, the taxpayer must rent out the dwelling unit at fair market value for at least 14 days or more; and, personal use of the dwelling unit must not exceed the greater of 14 days or 10% of the total number of days that the unit is rented out. If these guidelines are all observed, then the eligibility of the dwelling unit won’t be challenged. Again, it’s still possible to conduct a successful exchange without strictly observing these guidelines, but staying within these lines is strongly advised as a matter of risk containment.
Ultimately, whether a given transaction succeeds or fails depends on the fulfillment of the underlying elements of Section 1031, not on the fulfillment of the IRS’s interpretation of those elements (unless that interpretation is consistent with judicial opinion). This Rev. Proc. provides guidelines for complying with the holding requirement of 1031. If an investor cannot, or prefers not, to comply with the guidelines in this document, then the IRS will have an argument that the vacation home isn’t actually “held for” investment. As a result, the tax deferral component of the transaction can be lost. Since 1031 transactions typically involve such large tax liabilities, the best course is almost always to abide by the IRS’s interpretations.
Fair Market Rent
In the context of Sec. 1031, “fair market rent” is determined by all of the relevant facts and circumstances of each case. There is no fixed formula for determining whether the fair market rent guideline is met in any given scenario. If the rent is reasonably consistent with market trends, then the fair market rent guideline will likely be satisfied. This issue tends to surface most frequently when the second property is rented out to a relative, as relatives are often charged rents which are at variance with market trends. This is another way that the holding requirement may be impugned. If you do decide to rent out your second property to a relative, you must charge rent which doesn’t deviate too far from what is normally expected in the wider rental real estate market.
Advantages of Using Vacation Homes in a Sec. 1031
To those unfamiliar with its provisions, this Revenue Procedure should come as excellent news for investors. This document provides clear, concise guidance for investors who wish to possibly utilize vacation homes in a Sec. 1031 tax-deferred exchange at some point in the future, and the requirements are quite modest. Investors can rent out their incidental property, use this property on a limited basis, and then eventually swap that property for another, potentially better performing property in an exchange. This document gives a convenient, easy way for investors to both enjoy their vacation home and at the same time capitalize on their investment.
Our New York City Tax Attorneys Can Help
The attorneys at Mackay, Caswell & Callahan, P.C. spend considerable time poring over abstruse technical documents such as Revenue Procedure 2008-16. We do this to ensure that we’re competent in our areas of practice, and so that our clients don’t themselves have to spend time pondering this type of dense material. If you’re preparing to conduct an exchange involving a vacation home, or if you have any other tax issue, be sure to give one of our tax lawyers in New York, NY a call and we will get your issue sorted out right away!
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