February Feature Article

By Neil L. Friedman

Exchanging Vacation Homes

I.R.C. Section 1031 is one of the most taxpayer-friendly sections of the tax code. Section 1031 states that no gain or loss shall be recognized on the sale of property held for investment, or property used in a trade or business, as long as the taxpayer reinvests in "like-kind" property within 180 days.¹ However, the definition of property held for investment is sometimes open to debate.

One scenario that we are often presented with is the taxpayer who wants to use Section 1031 to defer the taxes due on the sale of their highly appreciated "lake home." Their rationale is that they would not have acquired the property if they had not thought it would appreciate substantially in value and therefore would be a good investment.

These taxpayers are amazed when we suggest there may be some question about whether this transaction would qualify for Section 1031 treatment. They ask, "How could this not be an investment? It doubled in value in the last four years." The answer is that from a financial or economic perspective, it was a wise deployment of capital, but from a tax perspective, it can only be considered an investment if its personal use was only "incidental." While the regulations of Section 1031 do not define "incidental," under depreciation rules, personal use cannot exceed the greater of 14 days a year or 10 percent of the time the property was rented. Personally used property and investment property are mutually exclusive concepts in the Code. Therefore, a lake home used primarily by the taxpayer and their family is not an eligible 1031 asset.²

A recent tax court case illustrates this situation. In the case of Barry E. Moore & Deborah E. Moore v Commissioner, Tax Court Memo 2007-134, the taxpayers (husband and wife) had lived in Southern Georgia and had acquired a lake home they used on weekends. They then moved to the Atlanta area, more than five hours away from the lake home. Instead of acting as prudent investors would, and making an attempt to rent the property, they chose to leave it vacant. Then they decided to acquire a second lake home closer to Atlanta, which they also used personally.

Subsequently, the couple divorced and had to dispose of both lake homes as part of that proceeding. They argued that the sales qualified for Section 1031 treatment because, when acquired, they believed the property would appreciate in value. While the Tax Court confirmed that acquiring a property for appreciation may constitute a valid investment intention, that intention must be the "primary" or "principal" motivation for the purchase.

The Court held that the taxpayers, by using the property for personal recreational enjoyment, demonstrated their primary motivation was not appreciation, but personal use. They failed to act as prudent investors would - at a minimum, this would mean advertising the property for rent at fair market value, showing income, if any, and taking depreciation on their tax return. Notwithstanding that the properties had appreciated substantially in value, they did not meet the "qualifying use" test of Section 1031. Therefore, the gain on the sale was fully taxable.

It is possible, however, given time and the proper set of circumstances, for a family lake home's primary use to be converted from one of personal use to that of property held for investment. A Qualified Intermediary, such as IPX1031, can help property owners map out a strategy to take full advantage of the benefits of Section 1031. It is also recommended that taxpayers consult their trusted advisors for tax and legal advice in this matter.

¹ There are a significant number of other rules and regulations regarding a successful exchange, which are beyond the scope of this article.

² The Tax Code provides relief to taxpayers selling a primary residence (Section 121), but there is no relief at all for the sale of a second or vacation home.