IRS Issues Vacation Home Ruling

The IRS has just issued a new ruling that sets forth the guidelines for those taxpayers that wish to do a 1031 exchange involving a vacation home. While I believe that the IRS intends that the ruling will put to bed all of the controversy surrounding this issue, it will certainly create more controversy than it settles.

By way of background, you can only exchange property held for investment or used in a trade or business. Personal use property, such as a residence, does not qualify for an exchange; so the question is: are vacation homes investment property or personal use property? Up until last year there was no guidance from the IRS that said that vacation homes do not qualify for an exchange, but that changed when the U.S. Tax Court disallowed a taxpayer’s exchange from one vacation home into another.

One of the problems with the court case is that the taxpayer made no attempt to argue that their vacation homes were investment property; they didn’t counter the IRS arguments that they were personal use homes (which in truth it sounds like they were). The court case immediately gave rise to the question of what has to be done to qualify a vacation home for a 1031 exchange? - this ruling is the IRS attempt to answer that question.

...the question is, what has to be done to qualify a vacation home for a 1031...?

The ruling was released as a Revenue Procedure, which is a type of “cook book” ruling – it sets out what a taxpayer must do to achieve a certain result from the IRS. In this case the result is a promise from them that they will not dispute the investment nature of your vacation home – in other words, if you do certain things, your property is guaranteed to be treated as investment property.

So what do you have to do to achieve this result? First, the ruling imposes a 24 month holding period, for the Old Property if that is your vacation home, or the New Property if you intend to buy a vacation home, or for both if you’re moving from one vacation home to another.

For each 12 month block of this holding period you must have rented the vacation home for at least 14 days at a fair market rent. The definition of fair market rent is determined at the time the rental is entered into. I’m not sure how they plan to police this because fair rent differs between properties within the same complex; it differs based on the time of year; and it differs based on who the tenants are. For example, I would rent my vacation home to a retired couple for less than I would rent it to a couple of college kids that want to stay there during Spring Break.

Also during each 12 month block, the owner is only allowed to use the property for the greater of 14 days or 10% of the days rented. This means that if you rented the property for 30 days that year, you could still use it for 14 days, but if you rented it for 200 you could use it for 20. Days that relatives use the unit, presumably for free, count against you (although I have to believe that will not be the case if they pay a fair rent).

Days that your partner uses the property also count against you. For example if you and Fred each own 50% of the property as tenants-in-common, days that Fred or his family use the property count against your 14 day allotment and effect your ability to do an exchange, just as your personal usage effects his. This will turn out to be a huge problem for those of you in co-ownership situations with vastly different objectives for the property.

Although not specifically discussed in the ruling, you are allowed a reasonable number of “maintenance days” to care for the unit. These days need to be reasonable - even the IRS knows that it doesn’t take a week to shampoo the carpets.

This ruling is effective for sales of property taking place after March 10, 2008. This could be a problem if you are under contract to sell a vacation home that will close after that date. But before you slit your wrist, just remember: this is a safe harbor ruling – it doesn’t mean that your exchange is toast if you fail, although you can expect closer scrutiny if you do get audited. Common sense would also dictate that the IRS will get more stringent with these guidelines as time goes on and people have had a chance to comply.

So what happens if you don’t meet the test? Again, remember: this ruling is a safe harbor ruling – if you fail, the IRS won’t automatically disallow your exchange, and they won’t automatically audit you. In other words, the fact that you used the property for 15 days two years ago will not automatically toast your exchange today.

Some of you have never rented, or tried to rent, your unit, and some of you have used it two or three or four months a year the last few years; this ruling is probably the death knell for your exchange. Most of our clients, however, actually come amazingly close to meeting it. My advice to all of you is to tighten up your record keeping and your tax reporting of your property. Be serious in your rental attempts; charge family members the going rental rate when they use it. Keep detailed records of the dates you use it and what you did – especially for each maintenance day. Your success at doing an exchange could very well come down to how good your records are.