Deferring Gain on Sale of Vacation Property

In light of current economic conditions, the vacation home market continues to be robust.  In the past few weeks, we have received inquiries regarding the use of the like-kind exchange strategy for clients who are considering selling their vacation homes in various markets.

Depending on your specific facts and circumstances, you may be able to defer gain in accordance with Internal Revenue Code (IRC) Section 1031.  

Generally, IRC Section 1031 provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind that is to be held for productive use in a trade or business or for investment.

There is well-established guidance that holds that the deferral provisions in accordance with IRC Section 1031 are not available for property that is used as a personal residence.  Holding a property as a residence with the hope or expectation that the property may be sold at a gain does not establish an investment intent.  

However, in recognition that taxpayers often hold dwelling units for the production of current rental income and also use the property occasionally for personal purposes, the IRS issued Rev Proc 2008-16, which provides a safe harbor for which the IRS will not challenge whether a dwelling unit qualifies as property for held for productive use in a trade or business for investment purposes.

Rev Proc 2008-16 defines a dwelling unit as “real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities.”

The IRS will not challenge whether a dwelling unit qualifies under IRC Section 1031 if it satisfies both the qualifying use standards as follows:

1. for relinquished property (property that you currently own) as follows:

  • the dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and 
  • within this period, in each of the of two 12-month periods immediately preceding the exchange, 
    • the taxpayer rents the dwelling unit to another person at fair rental for 14 days or more, and 
    • the period of the taxpayer’s personal use of the dwelling does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at fair value.

2. For replacement property (property that you will acquire):

  • the dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange; and 
  • within this period, in each of the two 12-month periods immediately after the exchange,
    • the taxpayer rents the dwelling unit to another person at fair rental for 14 days or more, and
    • the period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at fair value.

There are additional rules related to fair rental and personal use that are beyond the scope of this article.  Further, all of the other requirements of IRC Section 1031 must be satisfied in order to achieve deferral on the exchange of a second home or vacation home.

Please contact any member of our real estate industry group if you have any questions or would like to learn more about this valuable deferral technique.

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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