Personal Residences and Vacation Homes

"A newsletter devoted to the education of those involved in section 1031 exchanges"

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Many real estate owners contemplating like-kind exchanges under Internal Revenue Code ("IRC") §1031 face the same troubling questions. One such common question is whether a real estate owner can defer the gain from a sale of a "vacation home".

Pleasure or Profit? Sale of Vacation Homes

Whether it’s a condo in Florida or a cottage on Cape Cod, many Americans own second homes. The question that inevitably arises is whether the gain on the sale of a "vacation home" can be deferred through a like kind exchange under IRC §1031. The answer depends on the owner's use of the property prior to the sale.

Personal Residence Versus Vacation Home

Vacation homes may qualify under §1031 depending on the level of personal use by the owner prior to the exchange. The IRS maintains that a vacation home can only be considered investment property if losses from the sale or exchange of such property would be deductible. IRC §280A(d), which governs the deductibility of losses from a vacation home must be examined to determine whether a vacation home qualifies as investment property.

§280A disallows losses with respect to a dwelling unit used as a residence by the taxpayer during the taxable year. The unit is considered to be a residence if used by the taxpayer for personal use for more than 14 days, or 10% of the number of days during the year for which such unit is rented for fair market value. Personal use includes use by those related to the taxpayer, unless the relatives are using the same as a principal residence and paying fair market rent.

If a dwelling unit is a personal unit that is rented for more than 14 days out of the year, a limited amount of any losses may be deducted on a prorated basis. Based on the foregoing, it seems that a taxpayer could defer a prorated portion of any gain through a like kind exchange.

Although IRC §280A seems to control in determining whether a vacation home qualifies as investment property, losses on the sale of investment property can also be deducted under IRC §165, which allows that losses may be deducted if the transaction was entered into for a profit. A profitable sale must be the primary motive, not a secondary one. Accordingly, to deduct a loss under IRC §165 (and the exchange under §1031) the vacation home must have been purchased with turning a profit as the primary motive.

Planning Tips

A taxpayer who uses a vacation home for personal use more than incidentally will be hard pressed to qualify the same as investment property eligible for like kind exchange treatment. With proper planning, however, the taxpayer should be able to qualify their use of the property as follows:

(a.) The taxpayer should not exceed the personal use limitations of §280A(d) during the year of the sale;

(b.) The property should be rented at fair market rent during the year of the sale (or at least listed for rental);

(c.) If the personal use is significant, consider converting the vacation home to the taxpayer's principal residence in order to qualify the residence for the gain exclusion under IRC § 121.