Introduction

IRC section 1031 (“Section 1031”) requires that both the property transferred in an exchange (the “Relinquished Property”) and the property received (the “Replacement Property”) be held “for productive use in a trade or business” or “for investment.”² Property held for either of these two purposes is referred to in this article as “Investment Property.”³

Both the Internal Revenue Service (the “IRS”)⁴ and the courts⁵ have held that a principal residence cannot qualify as Investment Property. But what if a taxpayer has multiple reasons for owning a property, as frequently is the case with a vacation home?

Until recently, there were no court decisions or IRS pronouncements as to whether a taxpayer can exchange a vacation home and, if so, under what circumstances. On May 30, 2007, however, Moore v. Commissioner⁶ (“Moore”) was published. In Moore, the taxpayer had used both vacation homes (i.e., both the Relinquished Property and the Replacement Property) exclusively for personal use, never renting or even attempting to rent either property. The taxpayer did not claim tax deductions for maintenance expenses or depreciation and reported interest payments as home mortgage interest rather than as investment interest. In fact, the only basis for the taxpayer’s claim that the properties were held as Investment Property was the taxpayer’s hope that they would appreciate!

Not surprisingly, the Tax Court ruled against the taxpayer, holding that neither vacation home constituted Investment Property. Since the taxpayer’s position was so extreme and unreasonable, this case gave no guidance as to when a vacation home might qualify as Investment Property.

However, on February 15, 2008, the IRS provided a significant measure of certainty in this area by issuing Rev. Proc. 2008-16.⁷ This revenue procedure⁸ provides a “safe harbor” for exchanges of vacation homes whose requirements are both clear and reasonable.

Rev. Proc. 2008-16

The IRS frequently issues revenue procedures to provide guidance as to the minimum, or “safe harbor” requirements of a transaction which requirements, if met, will result in the transaction not being challenged by the IRS.⁹ Rev. Proc. 2008-16 (the “Rev. Proc.”) is just such a revenue procedure, as its stated purpose is to provide a safe harbor under which the IRS will not challenge whether a vacation home (labeled, in the Rev. Proc., as a “dwelling unit”) qualifies as Investment Property.¹⁰

The safe harbor applies to exchanges occurring on or after March 10, 2008.¹¹

The Safe Harbor Requirements

The Rev. Proc. actually enumerates two sets of requirements for the safe harbor, one applicable to Relinquished Property and one to Replacement Property.

The Rev. Proc. provides that Relinquished Property will be deemed to be Investment Property if:

1. The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the “Qualifying Use Period”); and
2. Within the Qualifying Use Period, in each of the two 12-month periods immediately preceding the exchange,
   1. The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more (I will refer to this as the “Rental Requirement”), and
   2. 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 that the dwelling unit is rented at fair rental (I will call this the “Use Limitation”).¹²

Similarly, Replacement Property will be deemed to be Investment Property if:

1. The dwelling unit is owned by the taxpayer for the Qualifying Use Period (i.e., at least 24 months) immediately after the exchange; and
2. Within the Qualifying Use Period, in each of the two 12-month periods immediately after the exchange, the taxpayer meets both the Rental Requirement and the Use Limitation.¹³

The Fine Print

There are several important things to note with regard to this safe harbor:

1. The personal use limitations apply not only to the taxpayer but to all family members, to anyone using the property under a “reciprocal arrangement,” and to anyone who is not paying fair rental for the property.¹⁴
2. The Rental Requirement and the Use Limitation are similar but not identical to those set forth in IRC section 280A, which governs whether, and to what extent, a taxpayer may claim business deductions for a vacation house.¹⁵ Therefore, merely because the taxpayer has taken business deductions for a vacation home in the past does not guarantee that the vacation home falls within the safe harbor. Conversely, even if a vacation home qualifies as Investment Property for exchange purposes, the taxpayer may not be entitled to take business deductions as to that vacation home.
3. If, in reliance on the safe harbor, a taxpayer reports a transaction as an exchange but the taxpayer subsequently fails to hold the Replacement Property for the Qualifying Use Period, or fails to meet the Rental Requirement or fails to comply with the Use Limitations as to that property, the taxpayer must file an amended return unless the taxpayer intends to claim a non-safe harbor exchange.¹⁶
4. The safe harbor applies only to the issue of whether the property in question qualifies as Investment Property and the taxpayer also must satisfy all other requirements of Section 1031.¹⁷
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Conclusion

The Rev. Proc. provides welcome clarification to an area of tax-deferred exchanges which has been largely unexamined by the IRS and the courts. Its provisions are liberal and straightforward. However, as with all safe harbors, the burden is on the taxpayer to establish that its requirements have been met. Therefore, accurate record keeping is essential!

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1. Richard A. Goodman is a partner in the Oakland, California, law firm of Goodman & Levine LLP. He is the author of Real Property Exchanges (California Continuing Education of the Bar 1982) as well as many articles on real estate and taxation, some of which are posted on his web page: www.the1031attorney.com. [Back]

2. IRC section 1031(a)(1).[Back]

3. Although in certain circumstances, property held “in a trade or business” receives different tax treatment from property held “for investment”, for purposes of Section 1031, property held “in a trade or business” and property held “for investment” are treated the same. [Back]

4. Rev. Rul. 59-229 and Rev. Proc. 2005-14, section 2.05. [Back]

5. Starker v. United States, 602 F. 2d 1341, 1350 (9th Cir. 1979). [Back]

6. Moore v. Commission, T.C. Memo. 2007-134. A Tax Court Memorandum decision, such as Moore, is reached by a single Tax Court judge. It is less authoritative, therefore, than one reached by a three judge Tax Court panel. [Back]

7. The full text of the Rev. Proc. can be accessed at www.irs.gov/pub/irs-drop/rp-08-16.pdf. [Back]

8. A revenue procedure is an official statement of a procedure that affects the rights or duties of taxpayers that believe the IRS should be a matter of public knowledge. Rev. Proc. 89-14, Section 3.02. [Back]

9. A safe harbor does not establish absolute and inviolable requirements. Thus, an exchange involving a vacation home may qualify as a tax-deferred exchange even though it fails to meet the requirements set forth below. [Back]

10. The Rev. Proc. 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.” Rev. Proc. 2008-16, Section 3.02 (unless otherwise indicated, all subsequent references are to the Rev. Proc.). [Back]

11. Section 5. The Rev. Proc. does not specify whether both legs of the exchange or merely the second leg must occur on or after March 10, 2008. [Back]

12. For both the Rental Requirement and the Use Limitation, 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 date) and the second 12-month period immediately preceding the exchange ends on the day before the first 12-month period begins (and begins 12 months prior to that date). Section 4.02(1). [Back]

13. For both the Rental Requirement and the Use Limitation, the first 12-month period immediately after the exchange begins 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. Section 4.02(2). [Back]

14. Section 4.03 and IRC Section 280A(d)(2). Fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered into. Section 4.04. [Back]

15. See IRC Section 280A(d)(1). Business deductions (technically called “expenses attributable to the rental of the unit”) include depreciation, maintenance and repair. Other deductions, such as mortgage interest, property taxes and casualty losses, are allowable regardless of the personal use of vacation homes or their rental to third parties. IRC Section 280A(e)(2). [Back]

16. Section 4.05. [Back]

17. Section 4.06. [Back]