Until recently, it has been unclear whether IRC Section 1031 applies to the “exchange” of vacation homes. In the absence of binding guidance, taxpayers often referred to a 1981 Private Letter Ruling (PLR) that seemed to indicate exchange treatment was available where the  taxpayer had acquired both the relinquished property and replacement property in hopes of future appreciation. While a PLR applies only to the taxpayer who sought the ruling, and only for that particular transaction, a substantial number of real estate professionals in seasonal or resort communities took full advantage of that ruling in their marketing efforts.

They would point out in PLR 8103117 the IRS permitted tax-deferred exchange treatment on a transaction involving so-called “second homes,” concluding that both properties were obtained “to make a sound real estate investment.” The taxpayer seeking the letter ruling was able to represent that during the six or seven years prior to the exchange, while the relinquished house had not been rented, it had only been occupied by the owner approximately 10 days per year for maintenance purposes.

When a second home does NOT qualify for a tax-deferred 1031 exchange

However, the recent case of Moore v. Commissioner offers new insight into the gray area of the impact of personal use of a second home. In Moore, the taxpayers had acquired the first property purely for personal use. It was never rented or offered for rent during more than 10 years of their ownership. On their tax returns the property was treated as a second home, with the taxpayer taking “home mortgage interest” deductions, and taking no deductions for investment interest, maintenance, or other expenses to which they might be entitled if it were a business or investment property.

The taxpayers’ argument before the tax court was “if investment intent is one motive for holding property, it is held for investment for purposes of Section 1031.” The Court pointed out in Starker v. United States it was recognized that “the longstanding rule that the exclusive use of property by the owner as his residence contradicts any claim by him that the property is held for investment.” The Court concluded that “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.”

Faced with no evidence that the taxpayers used either property for the production of income, and convincing evidence that they used the properties as vacation retreats, the Court held that neither the relinquished property nor the replacement property were held for investment, and denied 1031 exchange treatment to the transaction.

Your vacation home may qualify under certain circumstances

Generally, for property to qualify for tax deferral under Section 1031, it must be “held for productive use in a trade or business, or for investment.” Under the regulations governing Section 1031, real estate that is held by someone not a dealer in real estate for “future use or future realization” of appreciation is property that is “held for investment.” Thus, it would appear that property owners who never rented their vacation properties, but who can prove  they acquired and held their properties because they expected them to increase in value, may qualify for a §1031 tax-deferred exchange.

Seek advice to gain clarity

It is strongly advised that taxpayers seek the advice of their tax and legal counsel before attempting a 1031 Exchange using a vacation home. In doing so taxpayers may wish to inquire whether Sec. 5 of Rev. Proc. 2005-14, which is applicable to principal residences rather than vacation homes, might guide their actions with regard to converting personal use property.

Examples in that guidance indicate personal use property can be converted to “productive use in a trade or business” property by renting the same out and taking depreciation deductions for two years prior to the exchange. Taxpayers may also wish to explore with their advisors whether the tests under Section 280A(d) with regard to the deductibility of losses on vacation homes might inform their use of a vacation home in the years preceding an exchange.

Wilmington Trust can assist with your 1031 exchange

Wilmington Trust 1031 Exchange LLC is a nationwide provider of QI services. Our professionals have facilitated exchanges of all kinds, across the country and internationally. We will coordinate with your attorney and other professionals to ensure a smooth transaction at every step. We can help you complete both the disposition of your existing asset and the acquisition of your new one – from contract to closing.

IRC Section 1031 allows taxpayers to defer the gain on the disposition of business or investment real estate, if that real estate is replaced with like-kind real estate, within specific timeframes. Consult your tax or legal advisor for additional information on the requirements and limitations of such exchanges. Wilmington Trust 1031 Exchange LLC is a wholly owned subsidiary of Wilmington Trust, N.A. *Wilmington Trust 1031 Exchange LLC does not provide tax or legal advice to clients.