Thursday, June 01, 2006

Can A Vacation Home Qualify as a 1031 Exchange?

There are so many fine vacation homes available here in the White Mountains of Arizona, and the opportunity exists for buyers, if careful and educated, to avoid capital gains when selling real estate and obtaining their vacation home. Below is just a "thumbnail" of the process. You MUST consult with a CPA/attorney for your individual situation.

Can A Vacation Home Qualify as a 1031 Tax-Deferred Exchange?

Most tax and exchange professionals say "Yes", to the extent that the vacation home is used in part for rental purposes. As an example, if the vacation home is used 50% for personal use and 50% for rental or investment purposes, then 50% of the property is qualifying property held for investment purposes under IRC § 1031. The personal use portion of the vacation home will not be eligible for 1031 Exchange treatment, and neither can any expenses for that portion of personal use time be used as a deduction.


What if the vacation home is used partly for personal use and partly for investment purposes but is never rented out? In this case, the answer is "it depends. It depends on the amount of personal use of the property by the taxpayer. Property held for personal use does not qualify as investment property (IRC § 1031(a)). However, mere incidental personal use of property that is otherwise considered investment property does not disqualify the property from 1031 Exchange treatment (PLR 8103117). "Incidental personal use" is not defined by the Code, Regs. or by other guidance issued by the IRS.  Personal use of a vacation home for anything other than "incidental personal use" will disqualify a property if it is never rented out by a taxpayer.


Under what circumstances can all of the vacation home (100%) qualify for a 1031 Exchange? Code Section 280A(d) provides that if a taxpayer's dwelling is a 100% rental property (and not a "residence") if the taxpayers personal use of the property is less than the greater of -



  1. 15-days, or

  2. 10% of the number of days during the year for which the dwelling is rented (at fair market value rents). 


Personal use includes use by members of the taxpayer's family. Personal use does not include work days a taxpayer is at the residence. The purpose of IRC §280A is to limit deductions with respect to the rental use of a residence. Does 280A also define a property for purposes of a 1031 Exchange? Most tax and exchange professionals do not think so. However, compliance with the minimal personal use provisions under IRC §280A could be considered to be a safe-harbor for qualification of the property as a 100% eligible property for 1031 Exchange treatment.


As a last resort, if none of these rules will work for a taxpayer because of disqualifying personal use of the vacation home, then the taxpayer should consider converting the property to a qualifying investment property by discontinuing all personal use for up to a year or more  to position the property for a 1031 Exchange.  Renting the property will be a definite help for this purpose but is not mandatory.



Remember, Bruce & Pam, "Your White Mountains Realtors" only at Century 21 Sunshine in Show Low, Arizona, will help you find the right-priced vacation home for your 1031 Tax-Deferred Exchange! Send us your Vacation Home Requirements and we'll assist you every step of the way!


INTERMEDIARIES


To facilitate a 1031 exchange it is required to utilize the services of a qualified intermediary (QI), also known as a facilitator or accommodator. A QI is the person or entity that acts as the middleman in the exchange, providing the paperwork, oversight, escrow services and expertise necessary to assure that the exchange qualifies as an exchange under Section 1031 of the Internal Revenue Code. Even though a 1031 exchange is a complicated process, an exchange using a good QI can become a simple process and look surprisingly like a standard sale. The intermediary performs these services on a fee-for-service basis.

The QI facilitates the exchange of the relinquished property (the property you wish to sell) and the acquisition of the replacement property (the property you wish to buy) by having the sale and acquisition flow through the QI and by providing proper documentation to preserve the integrity of the transaction and to ensure the exchange complies with all government regulations. Furthermore, the QI safeguards the sale proceeds of the relinquished property and transfers those proceeds to the seller of the replacement property within the timeframe and guidelines required by law.


The IRS requires that intermediaries remain an independent third party from the seller or buyer of the property. The IRS defines a disqualified party as an individual who in the previous two years has served as your employee, attorney, accountant, investment broker, real estate agent/broker or relative.


In a 1031 exchange you cannot take physical possession or constructive receipt of the money resulting from the sale of your property. Therefore, since they are holding your money, it is very important to investigate the bonding, background, reputation and financial strength of a QI. The QI industry is largely unregulated, so it is very important to deal with a reputable, professional qualified intermediary.