Taxpayers use Internal Revenue Code (IRC) §1031 tax deferred exchanges to defer paying capital gain taxes. Frequently, a taxpayer may consider exchanging out of or into property held for investment in a vacation or resort area. Many tax and legal advisors believe it is possible to perform an exchange on a vacation property that is held for investment purposes, provided the personal use is incidental (generally less than 14 days a year or less than 10% of the time rented) and the taxpayer can substantiate that the primary purpose was to hold the property for investment, not personal use. A recent Tax Court decision, Barry E. Moore v. Commissioner, T.C. Memo 2007-134, provides a significant case concerning whether a vacation home would be considered “held for investment.” The court’s analysis also indicates certain tax planning strategies that taxpayers may wish to utilize when considering exchanging a vacation home.

LAKEFRONT PROPERTY EXCHANGED FOR LAKEFRONT PROPERTY

In Moore v. Comm., the taxpayers exchanged a lakefront vacation property with a mobile home in Lincoln County, Georgia (the Clark Hill property) for a lakefront property with a larger five bedroom and 4.5 bath house on 1.2 acres in Forsyth County, Georgia (the Lake Lanier property). The taxpayers in this case argued that both of these properties were held for investment, specifically for long-term appreciation purposes, and thus qualified for tax deferral under IRC §1031. However, based upon the taxpayers’ significant personal use of the property, the tax court concluded that both the relinquished Clark Hill property and the replacement Lake Lanier property should be viewed as “held primarily for the taxpayers’ personal use and enjoyment.” In reaching this conclusion, the court considered the following: (i) the taxpayers never rented or attempted to rent the property to others; (ii) the taxpayers deducted mortgage interest as a “home mortgage interest” expense rather than investment interest expense; (iii) the taxpayers did not take (and probably did not qualify for) depreciation or other tax benefits associated with an investment property under the Internal Revenue Code, including deductions for maintenance expenses.

The court accepted the taxpayers’ argument that both the relinquished and replacement properties were held for appreciation but concluded that “...the mere hope or expectation that the property may be sold at a gain cannot establish investment intent if the taxpayer uses the property as a residence. The proposition that holding a primary or secondary (e.g. vacation) residence motivated in part by an expectation that the property will appreciate in value is insufficient to justify the classification of that property as property ‘held for investment’ under Section 212(2) and, by analogy, Section 1031. There is no convincing evidence that the properties were held for the production of income, and there is convincing evidence that petitioners and their families used the properties as vacation retreats. The evidence overwhelmingly demonstrates that petitioners’ primary purpose in acquiring both the Clark Hill and Lake Lanier properties was to enjoy the use of those properties as vacation homes, i.e. as secondary personal residences.”

ADDITIONAL LEGAL PERSPECTIVES IN VACATION HOME EXCHANGES

In the tax court case, Rivera v. Commissioner (2004), the tax court noted that, “...the term ‘income’ is not confined to recurring income but may also apply to gains from the disposition of property.” In this case, the court found the owners held the property for investment purposes because they had purchased it with that the expectation it would increase in value. The court referenced Section 1.183-2(b) of the Income Tax Regulations that outlines nine factors indicating whether or not a taxpayer is involved in a venture that is intended to produce a profit. Although §1031 exchanges are not discussed directly, this section does define income and expense deductions for a vacation property and the intent to hold property as an investment.

Another reference for tax guidance on vacation home exchanges comes from Private Letter Ruling (PLR) 8103117 which states “...the house and lot you acquire in this trade will be held for the same purposes as the properties exchanged: to provide for personal enjoyment and to make a sound real estate investment.” Although a PLR only applies to the facts and circumstances in a specific situation, in this instance, some limited personal enjoyment of a property did not prevent a taxpayer from benefiting from a §1031 exchange. In this PLR, however, it is important to note that the personal use was minimal on the relinquished property in the years before the owners sold this property and initiated a §1031 exchange.

PLANNING STRATEGIES FOR A POSSIBLE VACATION HOME EXCHANGE

Despite the court’s conclusion in the Moore case, a taxpayer should be able to substantiate investment intent with proper planning, even with some limited personal use and enjoyment of the property (see T.C. Memo. 1997-401; Frazier v. Comm., T.C. Memo.,1985-61). The reporting of rental income, attempts to rent the property or the outright conversion of the property from a vacation property to a rental property before a sale of such property could be helpful in establishing investment intent. It also appears that a taxpayer would have a stronger argument if the property has been treated as an investment property on the tax return over a period of time. Obviously, there are tradeoffs in taking this position on the tax return in that eligibility for depreciation and other tax benefits associated with income and/or investment property may restrict the amount of personal use the taxpayer may make of the property. Most importantly, taxpayers should consult with their tax or legal advisors regarding any vacation home exchange.