I have a vacation property at Lake Tahoe that I’ve owned for several years. My kids have grown and aren’t interested in going there for vacation. Also, I’ve been too busy with my business to get up there much over the past few years. So I think that it’s time to sell it, but I have not placed it on the market yet. I think it will sell for about $800,000. My tax basis is $100,000, so I’m looking at about $700,000 of gain, which means approximately $105,000 of federal taxes and another $65,000 of California state taxes. Can I exchange the home under Section 1031 to defer the $170,000 in taxes?
A property must be held “for investment or in a trade or business” to be eligible for gain deferral under Section 1031. “Investment” means primarily for appreciation and not for personal use. Therefore, the Lake Tahoe property will only qualify if you hold it primarily for appreciation.
You will want to know what “primarily” means, of course. The Tax Court addressed this issue in 2007 in the case of Moore vs. Commissioner. The Moores owned a vacation home in Georgia. The family used the property for recreational purposes two or three weekends per month from mid-April to Labor Day each year. They would also visit the property intermittently during the “off season” to perform maintenance and other caretaking duties. The Moores moved to a new primary residence farther away from the vacation home and weren’t able to visit it. They decided to exchange it for a closer vacation home. They claimed an exchange on their tax return, stating that the vacation homes were held for investment. The Tax Court disallowed the exchange because the Moores’ primary intent was personal enjoyment and not investment. The Moores never rented out either vacation home, or even attempted to rent them out.
I guess that I should compare myself to the Moores. I’ve used the Lake Tahoe property about 15 to 20 days per year over the past few years. I have not rented it out other than to friends and family members. I did not want renters that I did not know. I’ve heard horror stories about irresponsible renters who caused thousands of dollars of damage. The rentals to friends and family amounted to about 10 days per year. I’m not sure if the rent I charged was fair market. I never checked for comparable rentals, although I’m sure other properties in the area are rented.
So you have issues similar to the Moores. While they did not rent their properties out at all, your rentals are minimal. You need to be concerned that the IRS might assert that you held the property primarily for personal purposes. Let’s look at other factors that go to the issue of investment intent. How have you treated the property on your tax return? The Tax Court pointed out that the Moores did not have investment intent because they did not claim depreciation or investment expenses on their tax return, and they deducted the interest on the mortgage as home mortgage interest. If you have taken similar reporting positions, you would have difficulty in an audit. I would recommend that you wait to sell the property and try to come within the IRS safe harbor for vacation homes. You have a lot of tax dollars at stake.
That seems wise. I’m not in a hurry to sell and I want to defer the taxes. What is an IRS “Safe Harbor” and what are the requirements to meet it?
This IRS recently issued Revenue Procedure 2008-16, and if you meet the requirements of this revenue procedure, the IRS will not challenge whether your vacation home qualifies as property held “for productive use in a trade or business or for investment” under Section 1031. That’s why it is called a “safe harbor”. Under the safe harbor, your Lake Tahoe property will qualify as for an exchange if it is owned by you for at least 24 months immediately before the exchange. You’ve met that requirement. However, in each of the two 12-month periods immediately preceding the start of the exchange: (i) you must rent the property to another person at a fair rental for 14 days or more, and (ii) your personal use of the property cannot exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the property is rented at a fair rental.
No Problem! I’ll just rent it to my kids for 14 days in each of the next two years, and limit my use to 14 days total. That sounds too good to be true. Will that get me
in the safe harbor?
That is too good to be true. The IRS is not that kind and gentle. The 14 day rental must be to unrelated parties. You are deemed to have used the property for personal purposes if used by you or your family members. So rentals to your kids, even at fair market rent, count as personal use by you and not towards the minimum 14 day rental requirement. Family members include your children and grandchildren, your siblings, and your parents. You can however rent to friends, in-laws or extended family members. You also can’t “trade” rentals with someone under a reciprocal use arrangement, even if rent is charged. Likewise, if you were to co-own the property with another person, you can’t rent to each other. For example, if you and your friend each owned a 50% interest in the property, you can’t meet the 14 day rental test by renting to each other. In short, you must rent the property to non family members for fair market rent. Any rental at less than fair market rent is counted as personal use by you too.
If you have a buyer in mind for the property, you may rent it to the buyer for the next two years and give the buyer an option to purchase the property with a reasonable earnest money payment too.
I have some friends that I could rent it to for 14 days or so. How do I determine what constitutes “fair market rent”? This seems to be an important key in fitting into the safe harbor.
You are correct that it is important. According to the Revenue Procedure, “fair market rent” is determined based on all of the facts and circumstances that exist when the rental agreement is entered into, and all rights and obligations of the parties to the rental agreement are taken into account. You should obtain an appraisal or other evidence from local rental agencies as to the fair market rent, at the time of the rental. Don’t wait till you’ve been audited several years later! Remember that you have significant tax dollars on the line and you want to go into an audit armed with good evidence of fair market rentals.
Don’t forget the other requirement. You and your family members cannot use the property for more than 14 days per year, or 10% of the rental days, if greater. This includes rentals to friends at less than fair market rental. I should mention that you may rent the property to your child if he or she uses it as a principal residence (and not a vacation home) and pays fair market rent. You may also be allowed some usage for repairs and annual maintenance, but be prepared to prove that you were there principally for that purpose. Have receipts, pictures, or other evidence of the work done.
This is great! I can apply some of the $170,000 in tax that I’m deferring to the cost of vacations to new places over the next two years. I’ve always wanted to go on a
cruise in the Greek Islands.
Yes, but remember to carefully document the rental to unrelated parties as well as your personal use. If you meet these requirements, the IRS cannot question whether the Lake Tahoe property is held for investment. Also, be sure not to claim the home mortgage interest deduction because it will not qualify since you are not using it for more than 14 days. And deduct the expenses related to the property as investment expenses under Section 212 of the Internal Revenue Code.
What about the replacement property in the exchange? Suppose I find a vacation home that suits my current needs, or would make a good retirement home later? How does the safe harbor work with respect to the replacement property?
You can do the same thing with the replacement property for the two years after the exchange. It will qualify as replacement property if you own it for at least 24 months immediately after the exchange, and, in each of the two 12-month periods immediately after the exchange, you rent it out to unrelated parties for 14 days or more. Like the Lake Tahoe property, your personal use of the replacement property cannot exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental. Generally, all the safe harbor requirements that we’ve discussed for the Lake Tahoe property will also apply to the replacement property.
Kevin A. Williams, President of North 1031 Exchange is currently the Managing Director of the North Wealth Management Company LLC. He has a Bachelor’s Degree in Economics and holds the following securities registrations: FINRA series 6, 7, 24, 63 & 65 and is licensed by the California Department of Insurance. He has allocated his talents to the institutional investment services arena for over 15 years. Kevin can be contacted at North 1031 Exchange, 4667 MacArthur Boulevard, Suite 220, Newport Beach, CA 92660. Toll Free: 866-700-1031 or 949-975-1031 or Kevin@north1031.com.