Sec. 1031 Exchanges of Vacation Homes

When does a vacation home qualify as investment property for purposes of a Sec. 1031 like-kind exchange? Based on the definition of “Use as Residence” in Sec. 280A(d), a vacation home used by the owner less than the greater of 14 days or 10% of the days rented at fair rental value during a year may qualify as investment property for Sec. 1031 purposes. It is much less clear whether a vacation home used by the owner for more than 14 days or 10% of the days rented would qualify under Sec. 1031. However, Rivera, TC Summ. Op. 2004-81, provides support for treating vacation homes as investment property when personal use exceeds the Sec. 280A limits.

Facts and Holding

In Rivera, the taxpayers used their vacation home for eight days and rented it for 23 days in 2000. Taxpayers had held the property for about 10 years and testified they had purchased it expecting that it would increase in value (which is did). The main issue was whether expenses incurred during the 11 months the property was vacant were incurred for the production of income under Sec. 212.

The Tax Court ruled that the property was held primarily for investment purposes; thus, the taxpayers could deduct expenses under Sec. 212. The court noted that the term “profit” includes the appreciation in value of assets and amounts realized in subsequent years, and is not confined to recurring income; see Regs. Secs. 1.183-2(b)(4) and 1.212-1(b). For purposes of allocating the appropriate expenses, the court divided the taxpayers’ use among personal, rental and investment activity.

Applying Sec. 1031

Sec. 1031 provides for the like-kind exchange of either “property held for productive use in a trade or business or for investment.” The Rivera court’s analysis of property held for investment should also apply to Sec. 1031 exchanges. Based on Rivera, there may be circumstances in which vacation homes used more than 14 days or 10% of the days rented qualify as investment property under Sec. 1031.

Because the taxpayers in Rivera used the property for only eight days during the year at issue, the question remains as to how much personal use will still enable the property to qualify as investment property. Based on a division-of-use approach, any amount of rental or investment activity should qualify the property for Sec. 1031 treatment, regardless of personal use. Under this approach, a portion of the proceeds from the sale of a vacation home would qualify for Sec. 1031 treatment, based on the time the property is held for investment or rental purposes.

Based on an all-or-nothing ap-proach, it is not clear the amount of time the property must be held for investment or rental purposes to qualify for Sec. 1031 treatment. However, Rivera may provide an opportunity for property used for personal purposes exceeding the greater of 14 days or 10% of the days rented to qualify for Sec. 1031 exchange treatment.

Documentation

Taxpayers should document their intent to hold their vacation home as investment property, and keep records each year of the rental, personal and investment use. Tax returns should reflect the rental use on Schedule E; investment expenses should be deducted as miscellaneous itemized deductions on Schedule A. Interest and real estate taxes are deductible separately on Schedule A.

Conclusion

The Rivera court’s view on vacation homes has opened the door for practitioners to suggest the application of Sec. 1031 to situations they may have previously ignored.

From Howard A. Stone, J.D., CPA, Frost, Ruttenberg & Rothblatt, P.C., Deerfield, IL