Does My Vacation Property Qualify for 1031 Exchange Treatment?

I can't tell you how many debates I have listened to or participated in regarding vacation homes or vacation property and whether it does or does not qualify for 1031 exchange treatment. The arguments were always the same. Would the IRS consider the property held for personal use or held for investment?

The more the vacation property or second home is held and used as investment property the better you were, and the more that you used the property for personal use the less likely it was that it would qualify for 1031 exchange treatment.

Moore vs. Commissioner
There was a court decision in Moore vs. Commissioner that held that a vacation home or vacation property must be primarily held for investment and not primarily held for personal use or enjoyment in order to qualify for 1031 exchange treatment.

Revenue Procedure 2008-16
The Internal Revenue Service issued Rev. Proc. 2008-16, which addressed this issue very well. It was in fact a very generous ruling in favor of the taxpayer. We updated our extensive article regarding the qualifications of a vacation property or second home and whether it qualifies for 1031 exchange treatment.

Safe Harbor Ruling
However, the Rev. Proc. only provides certain safe harbors. This means that if you fall within the safe harbors you will qualify for 1031 exchange treatment. But, it also means that if you fall outside of the safe harbors it does NOT mean that you do not qualify. It just means that you can not take advantage of the safe harbor provisions, but you must be extra careful when proceeding with your 1031 exchange going forward.

Strategic Thoughts
Vacation properties or second homes that fall outside of the Rev. Proc. may still qualify for 1031 exchange treatment. Taxpayers merely have to be more diligent in their planning to ensure a successful 1031 exchange.

Here are some thoughts that you may wish to consider:

• Rent out the vacation property or second home as much as possible.
• Put the vacation property or second home in a rental pool.
• Limit your personal use of the property to less than 14 days per year if at all possible.
• Don't use the property for any personal use in the year in which you will sell the property.
• Treat and report the property as investment property for income tax purposes, including depreciation (the IRS will tax you later on deprecation recapture whether you depreciated the property or not).
• Always charge fair market rental rates when you rent the vacation property or second home to your relatives and friends that use the property and make sure that you report this on your income tax return.
• The best of all solutions is to cease all personal use for at least 12 months before the sale and rent the property for 100% of that time. This way it is well documented that you are holding it for investment purposes and are collecting rent and paying taxes as investment property.

You can easily structure the sale of your vacation property or second home so that it will qualify for 1031 tax deferred exchange treatment if you follow the above suggestions and leave plenty of time to do so.

Deferred Sales Trust to the Rescue
However, for those who do not have time to properly structure the sale of your vacation property or second home for 1031 tax deferred exchange treatment, you may wish to consider the Deferred Sales Trust as a tax deferred solution on the sale of your property. Property does not have to be investment property in order to take advantage of the Deferred Sales Trust.