We are pleased to share this guest blog provided to our readers by Weiming Ping, Division Manager with Asset Preservation. Asset Preservation, a subsidiary of Stewart Title Company, is a leading national 1031 Exchange qualified intermediary who has completed over 200,000 1031 exchanges nationwide, and is efficiently handling exchanges throughout the country.
1031 Exchanges and Other Tax Aspects
Real estate in resort or vacation destinations can produce diverse and significant tax consequences. These tax consequences can be particularly critical at the time a property is sold, since many vacation destinations have appreciated significantly, and property owners may be facing significant capital gain tax consequences upon disposition. The use of a tax deferred exchange under Internal Revenue Service Code (IRC) Section 1031 can be particularly important in disposing of such property.
This blog will first address the use of Section 1031 tax deferred exchanges in disposing of vacation properties. It will then consider the tax consequences of several different scenarios both while the property is owned and upon disposition of the property. Last, it concludes with a few words about converting a vacation property into an investment property eligible for Section 1031.
Qualifying for a 1031 Exchange
Internal Revenue Code Section 1031 may be available for vacation property owners seeking to defer capital gain taxes on the sale of a vacation-type property. The main issue, in most cases, is whether the properties sought to be exchanged are held “for the productive use in a trade or business or for investment,” or whether they are held exclusively for the personal use of the taxpayer. The starting point in addressing this issue is Revenue Procedure 2008-16.
Rev. Proc. 2008-16 creates a “safe harbor” for exchanges of vacation property if specified ownership and use requirements are met. The property must include a sleeping space, bathroom, and cooking facilities (e.g., be a residential property). The property must further qualify as follows:
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- Must be owned by the property owner for at least 24 months immediately prior to the exchange
- Within each of the preceding 12-month periods prior to the exchange (a) the property owner must rent the property to another person or persons at a fair rental for 14 or more days; and (b) the property owner’s personal use of the dwelling unit must not exceed the greater of: 14 days, or 10% of the number of days the dwelling is rented out.
Non Qualifying Example
A 2007 Tax Court decision provides a good example of what will not qualify for a 1031 exchange of a vacation property. The property owners exchanged a lakefront vacation property for another lakefront property. The property owners argued that both properties were held for investment because of the potential for long-term appreciation, and thus qualified for tax deferral under Section 1031. However, the Court concluded that neither property was held primarily for investment purposes, but were instead held for their personal use and enjoyment. In reaching this conclusion, the Court considered that:
- The property owners never rented or attempted to rent the property to others;
- The property owners deducted mortgage interest as a “home mortgage interest” expense rather than investment interest expense; and
- The property owners did not take (and probably did not qualify for) depreciation or other tax benefits associated with an investment property including deductions for maintenance expenses.
Does the Vacation Property Qualify for a 1031 Exchange?
There are several factors to consider in evaluating a possible 1031 exchange opportunity:
- Has the property been shown on one or more tax returns as an investment property or property used in a trade or business, including the characterization of mortgage interest as deductible investment interest expense or business expense?
- Are the property improvements eligible for depreciation?
- Is the property used substantially as a personal vacation property or second home? The characterization of residential property as held primarily for investment or for use in a trade or business is often unclear, and dependent upon the particular facts and circumstances.
Tax Treatment During Ownership: Different Scenarios
The following sections will consider a number of different fact patterns, and the tax consequences which may arise both while a vacation-type property is owned and upon disposition of the property. These four scenarios are described below.
VACATION HOME WITH NO RENTAL ACTIVITY
Tax Consequence during Ownership: A vacation home held strictly for personal use with no rental activity at all is considered a second home and does not qualify for the tax deferral benefits of a Section 1031 exchange. The mortgage interest and real estate taxes are tax deductions on Form 1040 Schedule A of the federal tax return. No other expenses, including repairs, maintenance, or insurance, are deductible.
Tax Consequences at Disposition: The property owner may be able to take advantage of the exclusion from capital gain provided by IRC Section 121 if they can establish this home has been their primary residence for twenty four (24) of the past sixty (60) months. Section 1031 non-recognition treatment is not available because the property has been held solely for personal use.
Keep in mind that when the property owner is splitting time between more than one residence, the IRS generally applies a couple of tests to determine which property is considered the “principal residence” for purposes of qualifying for capital gain tax exclusion under Section 121.
First, qualification as a principal residence is determined by the facts and circumstances. The property which the owner uses the majority of the time during the year will typically be considered the principal residence. However, other factors may be used in determining which property is the principal residence, as set forth in Treasury Regulation 1.121-1(b)(2). The factors include, but are not limited to:
- The time spent in a residence.
- The taxpayer's place of employment.
- The principal place of abode of the taxpayer's family members.
- The address listed on the taxpayer's federal and state tax returns, driver's license, automobile registration, and voter registration card.
- The taxpayer's mailing address for bills and correspondence.
- The location of the taxpayer's banks; and
- The location of religious organizations and recreational clubs with which the taxpayer is affiliated.
Second, after it has been established which property is the “principal residence,” the IRS will generally try to determine if the property owner has actually occupied the residence enough days to meet the 24-month requirement.
VACATION HOME RENTED LESS THAN 15 DAYS A YEAR
Tax Consequences during Ownership: If a second home/vacation home is rented less than 15 total days during the year, it is still considered a second residence. The property owner may exclude the rental income from their gross income regardless of the amount. The property owner will be able to deduct the mortgage interest and property taxes but they will not be able to deduct any of the other expenses associated with renting the home, such as any necessary repairs or maintenance expenses.
Tax Consequences at Disposition: This type of usage, which is still primarily as a second residence, provides the ability to exclude a portion of capital gain taxes to the extent the property owner qualifies under Section 121. A 1031 Exchange tax deferral is not available for this type of usage as the property will not meet required criteria.
VACATION HOME RENTED MORE THAN 15 DAYS A YEAR
Tax Consequences during Ownership: If a vacation home is rented more than 15 days during the year, the rental income must be included as rental income and added to gross income. The expenses associated with renting the vacation home can be deducted. The expenses associated with the vacation home must be allocated between personal and rental use and the amount of rental expenses that may be deducted will depend on the number of days the home was rented. The rental income will be reflected on Schedule E of the property owner’s federal tax return.
Tax Consequences at Disposition: This type of property may potentially qualify for a Section 1031 exchange, provided that the taxpayer and their tax advisors can establish that the ‘primary purpose’ of holding the property was for investment purposes. If the property owner has substantially more than two weeks of personal use per year, however, this may be difficult to establish (review previous discussion)
Converting a Vacation Home Into an Investment Property
A property owner can prepare in advance for a potential Section 1031 exchange in the future by converting a vacation home or second home into a property held for investment. There are a number of steps that can be taken to accomplish this, which may include some of the following actions:
- Keeping any personal use of the property to a minimum, under 2 weeks a year, and/or below 10% of the days the property is rented.
- Hiring a local property management company to make the property available for rental use.
- Listing the property for rental on popular websites such as VRBO.com, Airbnb, rentals.com, homeaway.com, vacationrentals.com, etc.; and
- Showing rental income on Schedule E of the property owner’s tax return and other tax treatment consistent with a rental investment property.
As always, it is important to consult with your legal or tax advisor before engaging in a Section 1031 exchange. A careful review of the unique facts and circumstances of a vacation property owner’s situation should be done before the decision is made to proceed with an exchange.
Understanding Your Options
Whether or not you plan to sell your vacation property, it is important that you understand your options and select a long-term tax deferral strategy that is most suitable for your overall objectives. We encourage you to contact the professionals at First Guardian Group as well as your personal tax and legal specialists to learn more about retaining the appreciated equity in your real estate investments while minimizing or even eliminating tax consequences. Please feel free to contact FGG1031 for more info.
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