Rising gas prices have caused many vacation property owners to reevaluate their “get away” options.   They still want a cottage on a lake, but the lake needs to be closer to home.  With proper planning, a tax-deferred exchange may help them realize that goal.

How much personal use is allowed? 
 
To qualify for tax-deferred treatment under §1031, both the relinquished and replacement properties must be held for investment purposes or for use in the taxpayer’s trade or business.  Property held for personal use does not qualify.
 
So what about vacation homes?  Personal use is usually why they were acquired, but how much personal use is too much?  Hopefully the properties will appreciate in value.  Is that sufficient to demonstrate the necessary investment intent?  Or does the property have to be rented out to be considered an investment?

Appreciation ≠ Investment

The Taxpayers in one case faced this exact dilemma.¹   They had lake property that was used 2 or 3 weekends in the summer, with maintenance visits in the off season.  They exchanged for property closer to home and used it even more often.  The Court disallowed the exchange, finding that the property was held primarily for personal use, not for investment.

The mere hope or expectation of appreciation was not sufficient to establish investment intent.  The Taxpayers never attempted to rent either property, never claimed deductions for maintenance or depreciation and deducted the interest as home mortgage interest.  Also, their failure to properly maintain the relinquished property was inconsistent with an investment intent.

The IRS Safe Harbor:  Revenue Procedure 2008-16 

In 2007 the Treasury Inspector General for Tax Administration issued a report recommending additional oversight of like-kind exchanges, specifically stating that:  “…the IRS regulations for like-kind exchanges of second and vacation homes are complex and may be unclear to taxpayers…and little exists with respect to a published position by the IRS on like-kind exchanges involving such properties.”²

In response the IRS issued Revenue Procedure 2008-16, which provides a safe harbor.  If the procedures are followed, the IRS will not challenge whether a property qualifies as being held for productive use in a trade or business or for investment.  An exchange may fall outside the safe harbor and still qualify, but expect more scrutiny from the IRS.

Qualifying Properties

Both the Relinquished and Replacement Properties must have been owned by the Taxpayer for at least 24 months immediately before and after the exchange.  In each of the two 12-month periods immediately before and after the exchange the Properties must be rented at a fair market value for 14 days or more.  The Taxpayer’s personal use cannot exceed the greater of 14 days or 10% of the days during each 12-month period that the property was rented at a fair market value.

Personal Use

“Personal Use” is not limited just to use by the Taxpayer.  It also includes use by:

•   the Taxpayer’s family members;
•   any other person with an interest in the unit, or their families;
•   anyone using the unit under an arrangement which enables the Taxpayer to use some other dwelling unit (even if no rent is charged); or
•   anyone, if the property is rented for less than fair market value rent.

Meeting the Safe Harbor

First, you must meet the ownership requirements mentioned above.  You should also limit personal use of the property to the greater of 14 days per year or 10% of the rental period.  If you use the property any additional days for repairs and maintenance, be ready to show proof of the actual work done

The property should be rented to an unrelated party for at least 14 days per year.  However, there is no need to rent the property for more than 14 days.  You may also rent the property to a related party if they use it as their principal residence and pay fair market value rent.

It is also important to treat the property as an investment.  Make sure that the property is properly maintained.  Deduct expenses for maintenance, utilities, insurance and depreciation.  If you have a mortgage on the property make sure that it is structured as an investment loan, not as a loan for a primary residence. 

Vacation Homes Outside the United States

What if you own a vacation property located outside the United States?  In some cases you can still benefit from a 1031 exchange.  Real estate located outside the United States is not like-kind to real estate in the 50 states, even if it is located in an affiliated commonwealth or territory, such as Puerto Rico.³    However, you can exchange “foreign for foreign”, (e.g. Belize for Bermuda) as long as the other requirements are met.

A tax-deferred exchange is one of the few wealth building tools available to virtually any investor.  Taxpayers should consider the benefits of a tax-deferred exchange whenever they plan to sell property that is not their principal residence. 

We, at First American Exchange Company, look forward to working with you on your next exchange.  

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[1] Barry E. Moore et ux. v. Commissioner, T.C. Memo, 2007-134; No. 11002-03, May 30, 2007.

[2] “Like-Kind Exchanges Require Oversight to Ensure Taxpayer Compliance,” Treasury Inspector General for Tax Administration, September 17, 2007, Reference Number 2007-30-172.

[3] Exceptions have been made to include real estate in the U.S. Virgin Islands, Guam and the Northern Mariana Islands as “like-kind” to U.S. real estate.  See: PLR 9038030; Temp. Reg. §1.935-1T(c)(1)(ii)(E).

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1031 Treatment for Conservation Easements

The decline in real estate development has provided an unexpected opportunity for land preservation.  Large tracts of land that were slated for new construction are now being sold in whole or in part to local and regional municipalities or open space organizations.  Certainly the sale of the entire fee interest in land held for productive use in a trade or business or for investment would likely qualify for a §1031 exchange.  Interestingly, the sale of less than a fee interest may also qualify for tax-deferral under §1031 if certain criteria are met.

The IRS has issued several private letter rulings finding that certain types of conservation and agricultural easements are like-kind to real estate.  A conservation easement is a voluntary agreement that allows a landowner to limit the type or amount of development on their property while still retaining ownership of the land¹.  Generally, the easement needs to be perpetual in nature and considered an interest in real estate for state law purposes.

Typically the land owner receives cash in exchange for granting the easement.  Sometimes more than one government agency is involved in the transaction, such as a matching funds agreement between a county and state.  In those cases there may be issues coordinating the timely payment of funds from each agency.  It is a good idea to confirm how and when the sales price will be paid before entering the transaction.

There have been instances where the land owner received compensation other than cash in exchange for the easement.  In a private letter ruling² the IRS approved an exchange where the taxpayer received stewardship credits as compensation.³ 

First, using a Qualified Intermediary, the taxpayer conveyed the relinquished property by granting the county a perpetual restrictive stewardship easement over ranch land in return for stewardship credits equal to the value of the property rights that the taxpayer permanently relinquished. During the exchange period, the taxpayer converted the credits to cash by selling them to a third party buyer. The cash was then used to purchase the replacement property.  The taxpayer was never in receipt of the credits or the relinquished property proceeds during the exchange period.  The stewardship easement was held to be like kind to a fee interest in real estate.

The IRS based its decision on the fact that the stewardship easement was considered an interest in real property under state law and that the easement was perpetual. The ruling also discussed how the sale of the easement significantly and permanently restricted the future use of the taxpayer’s property such that the fair market value of the property, if sold, would be impaired.

  

In summary, remember that a §1031 exchange opens many investment opportunities for property owners.  Do not assume that you can only exchange fee interests for other fee interests.  There are many other possibilities, including conservation easements, leasehold interests and water rights. Please feel free to contact your local First American Exchange Company office to discuss your options:  (800) 556-2520; 1031@firstam.com.

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[1] The concept is similar to a “covenant running with the land”, which imposes binding conditions on future owners of a parcel of land.

[2] PLR 200649028.                                                                      

[3] These credits were essentially development rights, which allowed the holder of the credits to build elsewhere in the county at an increased density that would not otherwise be permitted.