Tax-Deferred Exchanges of Vacation Homes

By Phil Schurrer, CPA, MBA

Editor: Kevin F. Reilly, J.D., CPA

With the issuance of Rev. Proc. 2008-16, the Service has carved out a safe harbor for the exchange of vacation homes to qualify for Sec. 1031 treatment. The focus of this pronouncement is a vacation home used occasionally for personal purposes but predominantly used in either a trade or a business or for investment purposes. This revenue procedure applies to transactions occurring on and after March 10, 2008. If taxpayers adhere to the rules of this pronouncement, the IRS will not challenge the eligibility of an exchange of a vacation home under Sec. 1031 if the property is occasionally used as a personal residence.

This item briefly examines the historical backdrop of Rev. Proc. 2008-16 and highlights the tax concepts that have led to the creation of this new safe harbor. It also focuses on the Code sections that relate to this revenue procedure.

Background

In Rev. Rul. 59-229, the Service stated that a personal residence does not qualify as property held either for productive use in a trade or a business or for investment purposes. Therefore, a personal residence will not qualify under either of the two categories of property eligible for gain deferment under Sec. 1031.

The facts in Rev. Rul. 59-229 consisted of three separate scenarios: an exchange of farms with unharvested crops, an exchange of reciprocal mortgages, and an exchange of personal residences. The Service maintained that the tax treatment of the gain resulting from the exchange of residences fell under the purview of Sec. 1034 (subsequently repealed by the Taxpayer Relief Act of 1997, P.L. 105- 34) and thus was disqualified from Sec. 1031 tax-deferred treatment. The Service opined that, had the residences been occupied by tenants working on the farm at the time of the exchange, the result would have been different: The residences would have constituted property used in a trade or business and thus been eligible for Sec. 1031 treatment.

In Starker, 602 F.2d 1341 (9th Cir. 1979), the taxpayer exchanged timberland for 12 parcels of land. The Ninth Circuit ruled against tax-deferred treatment for one of the parcels because it was a personal residence. The court noted, “It has long been the rule that the use of property solely as a personal residence is antithetical to its being used for investment” (emphasis added). The use of the word “solely” has led to further elaboration and refinement of this concept and arguably led to the issuance of Rev. Proc. 2008-16.

Rev. Proc. 2005-14 was drafted to give taxpayers guidance when the rules relating to like-kind exchanges and the limited exclusion of gain from sale of a personal residence coexist in the same transaction. It also reiterates the Service’s position that property used solely as a personal residence is disqualified from Sec. 1031 treatment. Rev. Proc. 2005-14 stated that taxpayers could use Sec. 121 (relating to the limited exemption of gain on sale of a personal residence) and Sec. 1031 in the same transaction, but three of the examples given in the revenue procedure clearly showed that the property being exchanged was not being used as a personal residence at the time of the exchange.

The three examples given were:

  1. Property formerly used as a residence but used as a rental at the time of the transaction;
  2. Two separate buildings, one a personal residence and the other used as an office;
  3. A personal residence, with an allocated portion used as a home office.
These scenarios described in Rev. Proc. 2005-14, their computations, and tax results are shown in the exhibits.
Example 1: X, a single taxpayer, purchases a house in 2000 for $210,000. She uses it as her principal residence from 2000 to 2004. From 2004 to 2006, the property is rented. Depreciation claimed during the rental period is $20,000. In 2006, X exchanges the house and receives $10,000 cash and a townhouse with a fair market value of $460,000. X intends to rent the new townhouse to tenants.
Exhibit 1: Tax results for Example 1

FMV of new townhouse

 

$460,000

Cash (boot)

 

10,000

FMV of old residence

 

470,000

 

 

 

Basis of old property

 

 

    Cost

210,000

 

    Less accumulated depreciation

(20,000)

190,000

Realized gain

 

280,000

Gain excluded under Sec. 121

 

(250,000)

Gain deferred under Sec. 1031

 

30,000

 

 

 

No gain recognized because boot did not exceed total amount of the gain

 

 

 

 

 

Basis in replacement property

 

 

    Basis in relinquished property

 

190,000

    Gain excluded under Sec. 121

 

250,000

    Less cash received

 

(10,000)

    Net basis in replacement property

 

430,000

Example 2: Y purchases property for $210,000 in 2001. The property consists of two separate dwelling units—a house and a guesthouse. Y uses the house as a principal residence and the guesthouse as an office, in which Y conducts a trade or business. Based on the square footage, Y allocates two-thirds of the expenses to the residence and onethird to the office. Between 2001 and 2006, Y claims $30,000 depreciation for the business portion of the property. In 2006, Y exchanges this property for a separate residence and office. No boot is given or received.
Exhibit 2: Tax results for Example 2

FMV of replacement house

240,000

 

 

FMV of replacement office

120,000

 

 

Total FMV of replacement property

360,000

 

 

 

 

 

 

 

Total

2/3 residence

1/3 business

FMV of replacement property

360,000

240,000

120,000

 

 

 

 

Cost of old property

210,000

140,000

70,000

Less accumulated depreciation

(30,000)

-0-

(30,000)

Adjusted basis

180,000

140,000

40,000

 

 

 

 

Gain realized

180,000

100,000

80,000

Gain excluded under Sec. 121

(100,000)

(100,000)

-0-

Gain deferred under Sec. 1031

80,000

-0-

80,000

 

 

 

 

Basis in replacement property

 

 

 

   FMV of replacement property

360,000

240,000

120,000

   Gain deferred under Sec. 1031

(80,000)

-0-

(80,000)

   Net basis in replacement property

280,000

240,000

40,000


Example 3: Z purchases property for $210,000 in 2001. The property consists of one dwelling unit. Z uses two-thirds of the house as a principal residence and one-third as an office in which Z conducts a trade or business. Based on square footage, Z allocates two-thirds of the expenses to the residence and onethird to the office. Between 2001 and 2006, Z claims $30,000 depreciation for the business portion of the property. In 2006, Z exchanges this property for a separate residence and office. No boot is given or received.
Exhibit 3: Tax results for Example 3

FMV of replacement house

240,000

 

 

FMV of replacement office

120,000

 

 

Total FMV of replacement property

360,000

 

 

 

 

 

 

 

Total

2/3 residence

1/3 business

FMV of replacement property

360,000

240,000

120,000

 

 

 

 

Cost of old property

210,000

140,000

70,000

Less accumulated depreciation

(30,000)

-0-

(30,000)

Adjusted basis

180,000

140,000

40,000

 

 

 

 

Gain realized

180,000

100,000

80,000

Gain excluded under Sec. 121

(150,000)

(100,000)

(50,000)

Gain deferred under Sec. 1031

30,000

-0-

30,000

 

 

 

 

Basis in replacement property

 

 

 

   FMV of replacement property

360,000

240,000

120,000

   Gain deferred under Sec. 1031

(30,000)

-0-

(30,000)

   Net basis in replacement property

330,000

240,000

90,000


In May 2007, the Tax Court in Moore, T.C. Memo. 2007-134, ruled that taxpayers who sold their vacation home and purchased another were not entitled to exclude gain from the sale of the first home under Sec. 1031 because the properties were not held primarily for use in a trade or business or for investment. The fact that the taxpayers held the property partially because its value was expected to increase was insufficient to qualify the transactions for gain exclusion under Sec. 1031. The evidence established that the couple and their children used the property as a vacation retreat, did not rent it out or claim depreciation or investment interest expense on it, and stopped maintaining the property after they ceased using it for personal purposes.

During the proceedings in Moore, the taxpayers pointed to their expectation of appreciation of the property and attempted to use that expectation to demonstrate that the property was held for investment purposes, thus qualifying under Sec. 1031. The court dismissed the argument, noting that an increase in appreciation has to be the primary motive of ownership, not merely an additional motive for ownership, for the property to qualify as being held for investment. The court noted that a longstanding rule in this area provides that a taxpayer who uses property exclusively for a residence is barred from claiming it as being held for investment.

Moore is another link in a chain of tax case rulings, perhaps most famously expressed in the Starker decision, that the mere hope or expectation of appreciation will not by itself allow a personal residence to be transformed into investment property qualifying under the like-kind rules of Sec. 1031.

In Rev. Proc. 2008-16, the Service acknowledged that many vacation homes are not only held primarily for the production of rental income but are also occasionally used for recreational or vacation purposes.

Code Sections Affected

Sec. 280A: Sec. 280A limits the deductibility of expenses associated with vacation homes by establishing a link between their tax treatment and the amount of personal versus rental use. It creates three distinct routes for tax analysis of these types of property, based on three categories of use.
  1. Primarily personal use (Sec. 280A(g)): If property is rented for fewer than 15 days during the year, it is treated as a personal residence. Any income from rent is excluded, and any expenses other than property taxes, casualty losses, and mortgage interest are disallowed. For purposes of Rev. Proc. 2008-16, this use is irrelevant, since the revenue procedure contemplates that the property in question is being held primarily for use in a trade or business or for the production of income.
  2. Personal or rental use (Sec. 280A(c), (d)): If the rental exceeds 14 days in a year, and the personal use exceeds the greater of (1) 14 days or (2) 10% of the total days rented, the rental expenses must be allocated between personal and business use and, for tax purposes, the total rental expenses cannot exceed rental income. This scenario is also irrelevant for purposes of Rev. Proc. 2008-16.
  3. Primarily rental use (Sec. 280A(d)): If the property in question is rented more than 14 days in a year, and the personal use is not more than the greater of (1) 14 days or (2) 10% of the total days rented, the property will be considered to be primarily used for rental purposes. In this case, the expenses must be allocated between personal and business usage based on a fraction, where the denominator is the total number of days in use and the numerator is the number of days in use for rental or personal purposes. Note that in this situation the tax result may be that rental expenses exceed rental income, assuming that the passive loss rules are met. It is this use that fulfills the criteria of Rev. Proc. 2008-16.
The Service and the courts disagree about the method of allocating real estate taxes and mortgage interest between personal and business use. The IRS computes the interest and taxes using a fraction, the denominator of which is the total days in use (Prop. Regs. Sec. 1.280A-3(d)(4)), whereas the Ninth Circuit has held that the proper denominator is the total number of days in a year (Bolton, 694 F.2d 556 (9th Cir. 1982)). The court’s reasoning is that real estate taxes and mortgage interest are a function of the passage of time and accrue ratably over the year.

Sec. 1031: In order to qualify as a Sec. 1031 transaction and thus defer reportable gain, the transaction must meet four criteria:

  • The transaction must be in the form of an exchange;
  • The property exchanged must be of like kind;
  • Both the property being relinquished and the property being received must be held either (1) for productive use in a trade or business or (2) for investment purposes; and
  • The property cannot be property held primarily for sale or be other specifically excluded property.

Rules and Methodology for Rev. Proc. 2008-16

Rev. Proc. 2008-16 frames the safe harbor in terms of a dwelling unit. For purposes of this procedure, a dwelling unit is defined as real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations and includes sleeping space, a bathroom, and cooking facilities.

Rev. Proc. 2008-16 deals only with real property. Personal property used as a vacation home (such as houseboats and motor homes) that would otherwise qualify for Sec. 1031 treatment is excluded from the ruling’s safe harbor.

To take advantage of that safe harbor, the taxpayer must have owned the property being relinquished, as well as the replacement property, for the qualified exchange period. This period consists of 24 months prior to the exchange date for the property being relinquished and 24 months after the exchange date for the replacement property.

In each of the two 12-month periods that comprise the qualified exchange period, the taxpayer must rent, or have rented, the dwelling unit at fair rental value to another person or persons. This rental period complies with the requirements of being held “primarily for rental use” under Sec. 280A (see above). This requirement applies to both relinquished and replacement property.

If subsequent events prove that the transaction does not meet the rules of Sec. 1031, an amended return should be filed.

Conclusion

According to U.S. census data, as analyzed by the National Association of Realtors in May 2006, there are 6.8 million vacation homes in the United States as well as 37.7 million investment units. Despite the recent slowdown in the housing market and the decline in housing values, it is still reasonable to assume that taxpayers will continue to buy, sell, and exchange vacation homes.

Practitioners whose clients are exchanging vacation rental property occasionally used as a personal residence should be aware of the content of Rev. Proc. 2008-16 and the safe harbor it offers.
From Phil Schurrer, CPA, MBA, Bowling Green State University, Bowling Green, OH (not affiliated with PKF)


EditorNotes

Kevin F. Reilly, J.D., CPA, is a member of PKF Witt Mares in Fairfax, VA.

Unless otherwise noted, contributors are members of or associated with PKF North American Network.

For additional information about these items, contact Mr. Reilly at (703) 385-8809 or kreilly@pkfwittmares.com.

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