Exchanging Vacation Homes under Revenue Procedure 2008-16

The issue of whether a “second home” or “vacation home” qualifies for tax deferral under IRC Section 1031 has always constituted a major question asked by real estate investors. Knowing the specifics enables taxpayers to achieve a profitable and tax deferred disposition that will not be challenged by the IRS.

IRS Procedure 2008-16, effective March 2008, provides a safe harbor for exchanges of vacation homes (the IRS actually uses the term “dwelling unit” in the Revenue Procedure) and eliminated much of the uncertainty that previously existed in this area of the law. In a nutshell, the simplified ruling states that a “dwelling unit” will qualify as relinquished property under IRC Section 1031 if it meets the following criteria:

  • The dwelling unit must have been owned by the taxpayer for at least 24 months immediately prior to the exchange (defined as the “qualifying use period”).
  • During each of two 12-month periods constituting the qualified use period, the taxpayer must have been rented the property for a minimum of 14 days to a third party at a fair rate,  and:
  • The property must not, during each of those 12-month periods, have been used for personal use for more than 14 days or 10% of the number of rental days, whichever is greater.

To constitute qualified replacement property under a 1031 Exchange:

  • The replacement property must be owned by the taxpayer for a 24-month period immediately following the exchange.
  • During each of two 12-month periods constituting the qualified use period, the taxpayer must rent the property for a minimum of 14 days to a third party at a fair market rate,  and:
  • The property must not be used for personal use for either the greater of 14 days, or 10% of the total number of days rented, during each 12-month period.

“Personal use” is defined broadly as occupation by the taxpayer or any member of the taxpayer’s family. Also, use for which no fair rent is collected shall also constitute “personal use”.

“Fair rental” is based on all of the facts, conditions and circumstances that existed when the rental agreement was made.

There are some additional governing provisions. If you identify a replacement property under the guidelines and your situation changes during the two-year qualifying period, then you must file an amended return.

Although subject to greater scrutiny, an exchange of a vacation home may still qualify under IRC Section 1031 even if it fails to comply with all of the conditions set out under Rev Proc 2008-16.

As always, your best protection is to consult your tax adviser or attorney. At Peak, we specialize in 1031 Exchange transactions for all investors and property types. Whether you are a seasoned commercial investor or simply evaluating the impact of renting vacation property as part of your investment strategy, Peak 1031 Exchange, Inc. can assist you in structuring your transactions and offering valuable consultation.

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