Courts that have analyzed 1031 exchange eligibility of a property have generally concluded that the requirements are met if the property is held “primarily for investment.” Internal Revenue Code Section 1031(a) provides that:
"[n]o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment" (emphasis added)
In other words, if there is objective evidence that the taxpayer’s primary motive is to hold the property for investment, then limited use of the property by the taxpayer for personal enjoyment will not destroy the investment character of the property.
Difficulties in determining intent
It is easy to frame the issue, but it is often difficult to determine whether the taxpayer’s investment intent dominates an intent to hold for personal use. This is especially true when the taxpayer holds a vacation property and uses it from time to time. The practical difficulty is compounded by the IRS’s limited guidance concerning the requirements to prove that the property is held for investment. A recent Treasury Inspector General Audit report (“TIGA”) pertaining to the IRS’s enforcement of 1031 exchanges was critical of the IRS for its failure to provide guidance to taxpayers, thereby leaving unrebutted the claims of some promoters that vacation properties and second homes were generally eligible for exchange.
New 1031 exchange guidelines from the IRS
In response to the TIGA audit, the IRS has attempted to provide guidance to taxpayers concerning the exchange of vacation properties and second homes. Significantly, in February of 2008 the IRS issued Revenue Procedure 2008-16. Under the “safe harbor” created by this procedure, real property which is held for investment and also used for the taxpayer’s personal enjoyment will be treated by the IRS as held primarily for investment. The safe harbor requirements are met with regard to a property relinquished in an exchange if:
- The taxpayer has owned the relinquished property for no less than 2 years.
- In each 12 month period during the two year look-back period, the taxpayer has rented the property at fair market rent for 14 days or more, and the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10% of the days the property is actually rented at fair market rent.
Tthere are other technical niceties in Rev Proc 2008-16 relating to how days rented and days used are counted, but foregoing ownership and use requirements comprise the main features of the safe harbor test. Similarly, replacement property acquired in an exchange will qualify for the safe harbor if it is retained for two years and the previously mentioned use test is met during each of those 2 years.
Lingering gray areas in determining 1031 exchange eligibility
While Revenue Procedure 2008-16 will provide comfort for certain investors, it leaves many questions unanswered. Clearly, the ownership and use requirements set forth in the safe harbor are narrower than the range of properties that would qualify as held by the taxpayer primarily for investment. Section 1031(a) merely requires that the taxpayer hold the property primarily for investment. Where is the line between property that will be considered as held primarily for investment and property that will be considered held primarily for personal use and enjoyment?
Unfortunately, there is still no simple test to resolve that question. Courts have found that investment intent is lacking where there is evidence of substantial personal use of the property and the only objective evidence of investment intent is the taxpayer’s hope that the property would appreciate in the future. (See Barry E. Moore v. Commissioner, T.C. Memo 2007-134).
Considerations in determining eligibility
The IRS considers many factors to determine whether a property is held for investment, including:
- The investor’s intent and whether a primary motive for investment can be substantiated
- The length of time that the property is held by the taxpayer
- Whether the property was used to generate rental income
- The extent of the improvements made to the property
- The extent and timing of resale activities
In the Moore case (cited above), the tax court concluded that the property was held primarily for personal use and enjoyment after listing all of the things that the taxpayer failed to do that an investor would. The taxpayer had taken home mortgage interest deductions instead of investment interest deductions, had let the property fall into disrepair when the property was not being used by the family, and had never attempted to rent the property relinquished nor the property acquired in the exchange. In so holding, the court commented that the mere fact that a taxpayer believes a property might appreciate in value is not sufficient to establish investment intent when the property has been used solely for the personal enjoyment.
Maintaining "held for investment" status
There are a number of observations regarding exchanges of vacation homes that can be drawn from the safe harbor procedure and the Moore case.
First, an investor who exchanges a vacation property after the effective date of the Revenue Procedure and complies with all of its requirements will be treated as holding both properties for investment purposes.
Next, investors performing vacation home exchanges whose personal use exceeds the maximum permitted may still argue that the property has been held for investment under the standards outlined in Moore. The Revenue Procedure created a safe harbor for certain transactions, but there is clearly a large gap between the requirements in Moore and those within the terms of the Revenue Procedure. An investor can still substantiate that a vacation property has been held primarily for investment despite non-compliance with the Revenue Procedure.
Finally and most importantly, whenever an investor is considering an exchange, it is essential to consult in advance with a competent tax advisor regarding the details of the contemplated transaction.