VACATION HOMES---MORE PROBLEMS AHEAD

In order for a property to qualify for a Section 1031 tax deferred exchange, the property must be" held for" productive use in a trade or business or held as an investment.  Personal residences do NOT qualify for a Section 1031 exchange.   

A very important point I want to establish at the outset of this particular blog is that "the incidental use of the vacation home" will not necessarily taint the property otherwise held for investment.  This "held for" rule is determined at the time of the exchange and whether a particular property is held for a proper purpose is a question of fact.   

The reason why I am briefly educating you bloggers on this subject, is that I just returned from the FEA (Federation of Exchange Accommodators--the national trade organization for Qualified Intermediators) Convention.  It was pointed out in our Board of Directors meeting (I am on the Board) as well as at one of the general convention sessions, that IRS is getting stricter on its interpretation of whether a second/vacation home qualifies as an investment.  IRS's stricter interpretation is due to the recent, Moore v. Commissioner, T.C. Memo 2007-134 (2007) case. 

In that case the taxpayer owned a vacation home on the lake and used it around 2 to 3 weekends a month during the summer.  They had made numerous improvements to the property and never advertised or attempted to rent the property.  On their tax return, they did not claim deductions for investment interest, maintenance or repair costs.   The Tax Court found that the investment must be primary, not one of the motives for holding the property.   

In short, IRS is going to have you prove that it was an investment.  Did you rent it out?  Did you list it for rent with a Realtor or advertise the property for rent.  How much rent did you receive and did you pay taxes on that rent?  How many days a year did you use it personally?  What type of loan did you get on the property?--That's a real good question--because if you got a loan that was a second home loan(usually at a lower interest rate than an investment property loan) and you are saying this is an investment property, IRS could ask:  who did you lie to?--the Lender who gave you a second home loan not an investment loan or are you lying to IRS and this really is a second home and not an investment.  In either case they got ya. 

Finally, on another issue dealing with vacation homes, the Chicago Sun-Times reported last week that "The House Ways and Means Committee, seeking revenue to help homeowners in foreclosure, unanimously approved higher taxes on the sale of vacation homes."  They are trying to attack the use of Section 121 which allows taxpayers to exclude as much as $500,000 in profit from capital gains taxes.   This is not law yet--I as usual will try to keep you up to date.  We also have current news on Section 1031 on our website at:  Bayview1031.com.

Comments

[Stephen Wayner]

If you rent it for at least 2 years, you should have no problem proving to IRS that it was an investment property. I don't want to get technical in this brief response to your question, but you can have your CPA look at the newest addition to Section 121, which describes the process necessary to accomplish what you are describing. Your CPA can check out the very thorough dissertation on the subject I wrote in the January 2006 issue of THE CPA JOURNAL.

[Dan]

In reference to this part of your post:

"What type of loan did you get on the property?--That's a real good question--because if you got a loan that was a second home loan(usually at a lower interest rate than an investment property loan) and you are saying this is an investment property, IRS could ask: who did you lie to?--the Lender who gave you a second home loan not an investment loan or are you lying to IRS and this really is a second home and not an investment. In either case they got ya."

Aren't you able to change the "use" of the property? For example, you may have purchased as a second home and got that loan, but then ended up renting it enough to qualify as an investment for tax purposes. Is this not a legitimate change?