With it being vacation season when many people gather with families and friends at their vacation property, owners often wonder what they can do to address the tax ramifications of their vacation property should they decide to sell. Vacation property, especially those on Cape Cod and other high demand vacation spots, appreciate quickly and with that owners become concerned about the capital gain tax consequences upon the sale of the property. In other instances, real estate investors want to consider using proceeds from the sale of investment real estate to acquire a vacation or second home, utilizing the profits from the sale to defer the taxes. Over the last forty years, there has been some changes as to whether vacation property could be subject to a 1031 exchange – this article will detail the history and the state of the law in 2023 on vacation property 1031 exchanges so that vacation property owners can carefully consider the criteria to conduct a 1031 exchange on vacation property without running afoul of the Internal Revenue Code, whether they are acquiring or selling the vacation or second home.
Recap of What is a 1031 Exchange
Under Internal Revenue Code Section 1031, a taxpayer who owns real estate (“Owner/Investor”) can defer both state and federal capital gains tax and recapture depreciation taxes (which may represent approximately forty percent of the net sales price). It is imperative that the Owner/Investor meet the requirements of a 1031 exchange as any variation from the requirements will disqualify the transaction from being a 1031 exchange. It is important to communicate with your attorney and a qualified intermediary to make the necessary arrangements and execute the appropriate documents to set up the sale of the property as a 1031 exchange before the sale happens.
The History of 1031 Exchanges and Vacation Property.
Back in 1981, the Internal Revenue Service issued a private letter ruling that an Owner/Investor could conduct a 1031 exchange from vacation property to an investment property if the vacation property was used for investment purposes. This letter ruling was helpful but when the Treasury department issued the Deferred Exchange Regulations in 1991, the regulations appeared to contradict the private letter ruling causing confusion. The regulations suggested that a vacation home could not be subject to a 1031 exchange unless it could be demonstrated that the Owner/Investor intended to hold the property for rental, investment, or business use. This uncertainty continued until 2007 when a Tax Court Memo was issued that because the Owner/Investor’s real intent was to acquire, hold and use the property for personal use and enjoyment, the property was not eligible for such a tax-deferred exchange. The Court focused on the Owner/Investor’s intent at the time of the sale, not the owner’s original intent at the time of acquisition.
Clear Rules Set in 2008.
By 2008, the Internal Revenue Service responded to the vagueness of the rules and the law and clarified that a vacation home or second home could be deemed to have been converted to an investment property and therefore qualify for 1031 treatment. As part of its procedural rules, the IRS outlined the safe-harbor guidelines that would allow an Owner/Investor to sell their vacation or second home as part of a 1031 exchange. To fall within the safe harbor protection, the following requirements must be met:
- The property must be owned and held by the Owner/Investor for at least 24 months before the sale/exchange of the property. This is called the “qualifying use period;”
- The property must have been rented at fair market value rental rates to other people for at least fourteen (14) days or more during each of the preceding two years; and
- The Owner/Investor can only utilize the property for their personal use and enjoyment for no more than fourteen days during each of the two years prior to the sale OR ten percent of the number of days that the property was actually rented out to other people.
Acquiring Vacation Property as Replacement Property.
Some real estate Owner/Investors who are selling their interest in real estate want to acquire a vacation property or second home as the replacement property. Mirroring the above requirements, for the proceeds from the sale of investment property to acquire a vacation home, the Owner/Investor must:
- Acquire the replacement property and hold it for at least twenty-four months after the exchange (i.e., the qualifying use period”).
- Rent out the property at the fair market value to other people for fourteen days or more for each of the first two years of ownership.
- Limit their personal use to no more than fourteen days during each of the first two years of ownership or ten percent or less of the number of days that the property is rented out during that two-year period.
It is important to note several items in the requirements. First, the use of the property by the Owner/Investor includes use by their family members unless they pay fair market value. Any use that does not involve the payment of fair market rent is considered personal use by the Owner/Investor. The Internal Revenue Code defines “related party” to include the taxpayer’s family, siblings, spouse, and lineal descendants but does not usually cover aunts, uncles, nephews, nieces, in-laws. As to what “fair market value rates” is based on the facts and circumstances at the time the property is leased. An Owner/Investor should carefully consider and seek advice as to whether to include the property into a vacation rental pool, whether to hire a local property management company, or advertise the property for rent, what type of improvements should be made to the property (capital improvements that are geared specifically to the Owner/Investor could call into question the intent of the Owner/Investor), and the implications of maintaining personal items on the property (as this can suggest that the intent is not for investment purposes.) Finally, it is important to show rental income on Schedule E of the owner’s tax return and other actions consistent with owning a rental investment company.
Going Outside the Safe Harbor Guidelines
It is possible that an acquisition or sale can qualify for 1031 treatment if the above guidelines are not met however the Owner/Investor should exercise caution and consult with their legal and tax advisors as this can be more difficult. Revenue Procedure 2008-16.
Where things Stand in 2023
There has been talk in the past few years in Washington D.C. about “closing the 1031 loophole.” The current President’s budget once again contains provisions to put limits on 1031 exchanges – specifically cap the amount that can be deferred. Historically, these efforts have not been fully successful but only time will tell if Washington narrows or eliminates this provision. In the meantime, please contact us at Orsi Arone Rothenberg Turner LLP for help and guidance on this critical area of the law.
About Attorney Allison R. Lane
Attorney Allison R. Lane has over twenty-five years of experience in real estate, finance, and business law. She has a strong background in complex commercial real estate and has represented commercial lenders in high value financing transactions, including drafting loan documents, contracts and leases, and conducting due diligence.
Her experience includes a wide range of knowledge and skill in commercial and residential real estate transactions and commercial lending. She has worked with many clients ranging from individuals to nonprofits to for-profit institutions. Allison has extensive knowledge and experience in the areas of condominium law as well as complex title and survey matters.
She has also represented both lenders and borrowers in private lending as well as traditional financing matters and regularly works to secure corporate financing in preparing corporate documents concerning acquisitions, sales, and financing.
Contact Allison About a Real Estate Matter
If you have questions for Allison about a 1031 Exchange or if you would like to schedule a meeting with her please reach out to the firm at 781-239-8900 or email her directly alane@oarlawyers.com .
