New Rules for Vacation Homes: Limited Personal Use is OK

On February 15, 2008, the IRS issued a ruling providing a "safe harbor" for 1031 exchanges involving vacation homes.  Prior to this ruling, the lack of guidance by the IRS left 1031 exchange experts with a split of opinion as to whether even the smallest amount of personal use of a property would disqualify that property from the requirements of section 1031.

The rules are clear that personal residences cannot be exchanged tax-free under section 1031.  Furthermore, the Tax Court in the Moore decision in 2007 clarified that a pure vacation home, with no rental component at all, will not qualify for a tax-free exchange under section 1031.  Left open was the situation where a home was used partially as a personal vacation home and partially held for rental purposes.

This new ruling, Revenue Procedure 2008-16, provides that the IRS will not challenge the status of a home as held for investment if (i) the taxpayer owns both the relinquished property and the replacement property at least 24 months immediately prior to or 24 months immediately after, the exchange, as the case may be, and (ii) within the 24-month period prior to or after the exchange, in each of the two 12-month periods immediately preceding or subsequent to the exchange (a) the exchanger rents the home to another person at a fair rental for 14 days or more, and (b) the amount of personal use during each of the two 12-month periods immediately preceding or following the exchange does not exceed the greater of 14 days or 10% of the number of days during that 12-month period that the home is rented at fair rental.

Note that what constitutes personal use is determined under another provision of the Internal Revenue Code.  Further note that all other requirements of section 1031 must still be met.

This ruling applies to exchanges occurring after March 9, 2008 and no protection is provided by this ruling for exchanges taking place prior to March 10, 2008.

This guidance from the IRS is most certainly welcome, but it does not answer all of the questions involving exchanges of vacation homes.  In particular, this Revenue Procedure does not provide guidance to situations where the amount of personal use exceeds the amount set forth in this Revenue Procedure.  Therefore, exchangers are left with the patchwork of cases that existed prior to February 15, 2008.

If you are interested in exchanging your vacation home, or any other property, please call us toll-free at 1-877-395-1031 for more information.