Real Estate Articles » 1031 Exchange

No Vacation On 1031 Watch

By: Amy K. Walsh, CES®
Submitted: 02:35PM on Friday 24 April 2009

Well, the IRS finally did it. For many years qualified intermediaries, attorneys and CPAs have been deliberating what delineates vacation homes held for investment versus personal use. With the Regulations being somewhat gray in this area, the debate has raged on with interpretations and recommendations being examined, dissected, even heatedly argued. But with the Barry E. Moore et ux. v. Commissioner ruling in May 2007, the gavel came down on what many have purported to be one of the biggest questions regarding IRC §1031.

With very little to go on in the past, intermediaries and tax advisors have relied on what information was available, mostly the definition of personal use vs. investment according to Section 280A(d) or Section 165. The characterization of a dwelling unit used as a residence under §280A(d) is if the owner or family member uses the property rent-free or for less than 80% of fair market value rental for 14 days or 10% of the total time the dwelling is rented, whichever is greater. Does the owner get penalized for “personal days” while he is there making repairs and maintaining the property? Not so long as the usage is not excessive as to bring into question whether they were truly making repairs or trying to defraud under the guise of maintenance. One client went to his beach property to perform “routine maintenance” on a regular basis - on Monday, he mowed the right side yard. On Tuesday, he mowed the back yard. On Wednesday, he mowed the left side yard, and on Thursday he mowed the front yard. Considering that the lot at the property was less than 0.25 acre, this hardly qualifies as “routine maintenance.”

In the cases where §280A does not apply, §165 must then be utilized for verification of the qualifying use. The general rule of thumb under §165 is that a property should be bought strictly with the intent of a profitable sale, which must be the predominant motive and not secondary to personal usage. To qualify under §165, the property must be kept up, not used more than the limits of §280A, and the losses must be deductible from the sale or exchange of the property to receive deferral within the meaning of §1031.

The property in question must also have the correct type of financing according to its purpose as well. Residential properties that are purchased with a second home mortgage cannot be classified as rental property or held for investment legally - only personal use dwellings are eligible for these rates. Any property that is to be held for investment must have a business or investment financing structure with the higher interest rate than on a second home mortgage.

Therefore, since no bright line test existed, many tax advisors have taken the examples provided above, along with a scant few cases dealing with vacation home treatment, and have created their own witches’ brew of how to advise their clients. Until now. The Moore case is significant in that it provides substantial guidance as to how the Service looks at what qualifies as “held for investment.”

In 1988, the taxpayers bought Property A at Clark Hill Lake. From mid-April to Labor Day each year, the taxpayers and their family used the property recreationally for two or three weekends every month, as well as going intermittently in the off-season for maintenance and repairs. The taxpayers then moved their primary residence further away from the property and no longer used it, but no longer maintained it, either, and it fell into disrepair. In 1999, the taxpayers entered into a contract for an improved property at Lake Lanier, then assigned 25% of the purchase contract to an escrow agent hired to act on their behalf. The taxpayers disposed of the Clark Hill Lake property in early 2000 and purchased the remaining 25% undivided interest in the Lake Lanier property. Again, the taxpayers resumed their activities of two to three weekends a month at the property, and increased their personal use to include business entertaining and weekends in the fall. The taxpayers sold the Clark Hill property and acquired the Lake Lanier property, then tried to seek tax deferral under §1031, claiming that both properties were held for investment.

The Service disagreed. Upon audit, the IRS argued that, given the findings of fact in the case, the taxpayer’s primary purpose must be taken into account when ascertaining any “held for” definition. The taxpayers attempted to argue that the investment purpose should be satisfied if it was just one of several reasons for holding the property. The final word came from the Tax Court, who sided with the IRS, stating that the taxpayers’ primary intent was demonstrably personal use and not investment for both properties.

In the Tax Court’s analysis, it deemed the escrow agent to be an agent of the taxpayer, therefore treating the Lake Lanier property as if the taxpayers already owned it directly. By their established actions, the taxpayers’ primary use was recreation and personal use. They failed to claim any deductions for maintenance expenses or any depreciation for the properties, and their interest deductions for both properties were treated as home mortgage interest rather than investment interest. The Court also pointed out that the expectation of appreciation does not stand alone in establishing the “held for investment” purpose. Finally, the Court noted that the lack of maintenance and caretaking by the taxpayers was inconsistent with the intent to maximize an investment and make a profit - their upkeep was related only to their personal usage.

The Moore case has taken the §1031 industry much farther down the road of clarity with respect to the treatment of vacation homes. While the verbiage in the ruling does not specifically state that vacation homes primarily held for personal use do not qualify for tax deferral, the implication is fairly matter-of-fact. When it comes to significant personal use of a property, the lack of rental, and the tax reporting concerning a property, the cards are now on the table.