We receive frequent inquiries from clients who hope to avoid recognition of gain on the sale of a vacation home by participating in a like kind exchange of properties under Section 1031 of the Internal Revenue Code. There are a number of hoops that must be passed through, but the starting point is a determination that the property to be sold must have been used in a trade or business or held for investment and that the property to be acquired must also held for one of these purposes. Many vacation homes are held both for the personal use of the owner and family and to produce income when the family is not using the property. For many families it is the only way that they can afford to own a vacation home.
We have advised clients that, in our opinion, in order for a vacation home to qualify as an exchange property under Section 1031, it must not have been treated as a personal residence under Section 280A of the Code, which prohibits the deduction of operating expenses incurred to maintain the property other than the deductions allowed for interest and taxes that are generally available with respect to residences held for personal use. Under Section 280A, operating expenses such as those for insurance, repairs and utilities may not be deducted if the property is used by the owner and family members during the taxable year for the lesser of fourteen days or ten percent of the days in the taxable year during which it is rented to persons other than family at fair rental value.
We have found no case law or other authority expressly confirming our position, and we are aware that other tax practitioners take the position that it is not necessary for a property to satisfy Section 280A in order to qualify as an exchange property. These advisors rely primarily on the argument that many owners of vacation homes expect to enjoy a profit on the eventual disposition of the property, and therefore the property is held for investment. Recently, in Moore v. Commissioner, the United States Tax Court, without addressing Section 280A, held that a vacation home that had been used exclusively by the taxpayers and their family could not qualify as an exchange property because the primary purpose for which it had been held was their personal use although they may well have hoped to profit on the eventual sale of the property. The court held that the investment purpose must have been the principal purpose for which the property was held.
As noted by the Court, the taxpayers in Moore did not rent their vacation homes to produce income, and therefore the case does not completely foreclose an argument that a vacation home with a significant rental history should qualify as an investment property although deductions for operating expenses are limited under Section 280A; however, given that Congress has determined that a residence used for more than the period allowed under 280A should be treated as a personal residence for deduction purposes and the holding in Moore that the primary purpose for which an exchange property is held must be for use in a trade or business or investment, we continue to believe that property subject to the deduction limitations under Section 280A will not qualify for an exchange of like kind properties under Section 1031. Taxpayers should also take into account that a failed exchange under Section 1031 will often leave them without a ready source of funds to pay what is likely to be a substantial tax plus interest.
Therefore, if an owner wishes to dispose of a vacation home on a tax deferred basis, with assurance that the property qualifies for an exchange under Section 1031, it must first be converted to a rental property. Unfortunately there is no clear standard for this requirement. We generally recommend at least one and preferably two years during which the property qualifies for the deductions for operating expenses limited under Section 280A. Also, as mentioned above, the replacement property must also be used in a trade or business or held for investment and therefore must also be used as a rental property before it may safely be occupied as a personal residence.
To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding U.S. tax penalties.
Mr. Freeland represents businesses and institutions both as outside general counsel and in a broad range of transactions, particularly real estate related activities. His clients include a major Boston area university, real estate development firms and organizations involved in a variety of business activities. Mr. Freeland assists clients to organize and operate their businesses in a tax efficient manner.