Vacation Home Rentals May Qualify Under Sec. 1031
While personal residences are ineligible under IRS Section 1031 guidelines, vacation home rentals may qualify depending on the situation.
One of the requirements for use of Sec. 1031 is that the exchanged properties be held for productive use in a trade or business or for investment. Thus, as previously mentioned, personal residences are ineligible. However, IRS recognized that many taxpayers hold dwelling units – commonly referred to as vacation rentals – primarily for the production of current rental income, but also use the properties occasionally for personal purposes.
Rev. Proc 2008-16 provides a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies under Sec. 1031 even though the taxpayer uses it occasionally for personal purposes. All other requirements for a like-kind exchange under Sec. 1031 must still be met.
Safe Harbor
The standards that must be met for the dwelling unit to be considered to be held for productive use in a trade or business or for investment are as follows:
Relinquished Property
The taxpayer owns the dwelling unit for at least 24 months immediately before the exchange, and within that period, in each of the two 12-month periods immediately preceding the exchange:
-
The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
-
The taxpayer’s personal use of the property does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
The first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day), and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).
Replacement Property
The taxpayer owns the dwelling unit for at least 24 months immediately after the exchange, and within that period, in each of the two 12-month periods immediately after the exchange:
-
The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
-
The period of the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
The first 12-month period immediately after the exchange ends on the day after the exchange takes place, and the second 12-month period begins on the day after the first 12-month period ends.
Filing Return Before Qualifying Use Period Ends
If a taxpayer files a federal income tax return and reports a transaction under Sec. 1031 based on the expectation that a replacement dwelling unit will meet the qualifying use standards noted above, and later determines that the dwelling unit does not qualify, the return should be amended to report the transaction other than as a Sec. 1031 exchange.