Generally, Internal Revenue Code section 1031 provides that if you sell property held for productive use in a trade or business or held for investment and you acquire replacement property to be used in a trade or business or held for investment you can defer the reporting of the gain on the sale. Of course, there are additional requirements in order to properly defer the gain on such a transaction. An issue that sometimes arises in this type of transaction is what does it mean to hold property for investment purposes? In response to a United States Tax Court case holding against the taxpayer, the IRS issued a Revenue Procedure to establish a safe harbor rule for vacation properties being held for investment purposes.
In May, 2007, the United States Tax Court ruled that a taxpayer could not sell a vacation property and replace it with another vacation property using the held for investment purposes argument. The subject case was Moore v Commissioner, TC Memo 2007-134. An important factor in this case is that the taxpayers never attempted to rent the property to third parties, never in fact rented the property to third parties, and simply used the property as a second home or a vacation home. Additionally, the first vacation home was sold after the taxpayers had moved to another location which made commuting to the vacation home impractical and it had fallen into disrepair from lack of use or maintenance and the second vacation home was sold due to a need for liquidity resulting from an impending divorce.
In rendering its decision the Tax Court in citing Starker v United States, 602 F2d 1341 (9th Cir. 1979) stated that “it has long been the rule that use of property solely as a personal residence is antithetical to its being held for investment. Losses on the sale or exchange of such property cannot be deducted for this reason, despite the general rule that losses from transactions involving … investment properties are deductible. A similar rule must obtain in construing the term “held for investment” in Section 1031.”
Additionally, the Tax Court stated “the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.”
In response to the Moore case, supra, the Internal Revenue Service issued Revenue Procedure 2008-10. The purpose of the Revenue Procedure is to provide a safe harbor under which the Internal Revenue Service will not challenge whether a dwelling unit qualifies as property held for the productive use in a trade or business or for investment for purposes of Section 1031 of the Internal Revenue Code. To qualify for the safe harbor under this Revenue Procedure a taxpayer must own
the dwelling unit (“relinquished property”) for a period of twenty four months immediately before the exchange during which time for each twelve month period the taxpayer rents the dwelling unit to another person at a fair rental rate for fourteen days or more and the period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of fourteen days or ten percent of the number of days during the twelve month period that the dwelling unit is rented at a fair rental rate.
Additionally, with respect a replacement property to qualify under the Revenue Procedure, the same rental requirements and personal use requirements are mandated. Accordingly, in order to fall under this safe harbor a taxpayer must rent out the relinquished property and the replacement property and limit their personal use of the property to less than fourteen days or ten percent of the number of days that the property is rented at a fair rental rate.
Does this Revenue Procedure mean that if you use a vacation property that you rent out for fourteen days a year and also use it for personal recreation purposes for more than fourteen days that a previous like kind exchange will be invalidated? The simple answer to that question is “no, not necessarily.” Typical legalese, right? The Revenue Procedure only represents a “safe harbor” wherein if you meet its requirements the Internal Revenue Service will not challenge the qualified use of the property being for held for investment purposes. Accordingly, if you do not meet the requirements of the safe harbor you will be in the position of having to argue that you hold the property for investment purposes.
How will someone establish that they are holding the property for investment purposes or in the productive use of a trade or business if they are outside of the safe harbor? The first step will be to rent the property or attempt to rent the property and be able to substantiate your attempts if you are unable to rent it out. The more you rent the property and attempt to obtain a current return on the investment the better your chances for having a qualified use. The second step will depend on whether there is any debt associated with the property. If there is any debt associated with the property, the mortgage application should reflect the reason for the loan is for investment purposes or rental property rather than a second home, which reflects a personal transaction rather than an investment transaction. Further, any mortgage interest deducted should be deducted on a Schedule E for the rental property or as investment interest expense on Schedule A rather than as simple mortgage interest deduction on Schedule A.
Remember, generally, the statute of limitations for the IRS to make an assessment is three years from the date the return is filed. Accordingly, you could meet the requirements of the safe harbor for the first three years that you own the property and then convert the property to a purely personal use vacation property in order to defer the gain from the sale of the first property. There is no problem in converting the property to personal use and if you meet the safe harbor during the first three years there is nothing the Internal Revenue Service can do to attack the qualified use of the property.
As always, when dealing with taxes make sure you seek the advice of a qualified tax professional before engaging in any transaction. Proper planning is prudent when dealing in any transaction that could have a tax ramification. In accordance with Internal Revenue Service Circular 230, the information provided in this article is not meant and cannot be relied upon by a taxpayer to avoid the imposition of penalties by the Internal Revenue Service.