Vacation Homes: The Safe Harbor of IRS Revenue Procedure 2008-16
Colleague Ken Zacharias recently consulted with a client on the qualified purpose requirement for vacation homes, and we thought that it would be a great topic to share with our readers. Ken and his team in Wisconsin, which include Jake Caelwaerts and Brian DelVecchio, and Chicago-based Jim Milliken, make up our larger Section 1031 consultation team.
Some quick reminders and definitions for Section 1031 before we dive too deep into this topic:
- Section 1031(a)(1) requires that relinquished property is “held for” and that replacement property “is to be held for” a qualifying purpose, which is either “productive use in a trade or business” or “investment.” This is referred to as the “held for” or “holding” requirement.
- Section 1031(a)(2) states that “property held primarily for sale” is not eligible property for Section 1031 purposes, as either relinquished property or replacement property, even if it is used in a trade or business.
- There is no specific holding period requirement for either relinquished property or replacement property.
- The same principles apply when determining whether each is held for or is to be held for a qualifying purpose.
An exchange of investment property for other real estate to be used as a personal residence would not qualify under Section 1031; however, property that is used for both business and personal purposes may qualify to the extent that the property has a business or investment use. In other words, the portion of the property that has a business or investment use would be eligible for non-recognition under Section 1031. But, and let’s be clear here, the non-recognition treatment would not be available to the non-business use (personal use) portion of the property.
About 15 years ago, the IRS issued Revenue Procedure 2008-16, which included a safe harbor test under Section 1031 that would apply to vacation homes. If a taxpayer can meet the requirements of the test, then the IRS will not challenge whether a vacation home qualifies as property held for productive use in a trade or business or for investment under Section 1031. The safe harbor applies to a “dwelling unit,” defined as “real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities.”
Under the safe harbor:
- A dwelling unit that a taxpayer intends to be relinquished property in a Section 1031 exchange will qualify as property held for productive use in a trade or business or for investment if: (i) the dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange, also known as the “qualifying use period”; and (ii) within the qualifying use period, in each of the two 12-month periods immediately before the exchange, the taxpayer rents the dwelling unit to another person(s) at a fair rental for 14 days or more, and the period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
- A dwelling unit that a taxpayer intends to be replacement property in a Section 1031 exchange will qualify as property held for productive use in a trade or business or for investment if: (i) the dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange, also known as the “qualifying use period”; and (ii) within the qualifying use period, in each of the two 12-month periods immediately after the exchange, the taxpayer rents the dwelling unit to another person(s) at a fair rental for 14 days or more, and the period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
- Consult Section 280A(d)(2)-(3) for personal use tests, including the definition of and application to related parties.
- A fair rental rent is determined by the facts and circumstances that exist when the rental agreement is entered into, and all of the rights and obligations of the parties to the rental agreement. It is recommended that the taxpayer obtain sufficient evidence of fair market rent through an independent, third-party source.
- And lastly, just so this doesn’t get lost in translation: a taxpayer utilizing the safe harbor must also satisfy all of the other requirements for a like-kind exchange treatment under Section 1031 to qualify for non-recognition.
Ken, Jake, Brian and Jim want to hear from you. Please reach out with any questions. CLA is here to help!
Source: Bloomberg Tax, Thomson Reuters
- Carey M. Heyman, CPA
- Managing Principal of Industry - Real Estate
- CliftonLarsonAllen LLP
- Century City (Los Angeles)
Carey is the Managing Principal of the Real Estate Industry at CLA. He is a trusted advisor with close to 20 years of experience providing accounting, assurance, tax, and consulting services to real estate industry owners, operators, family offices, developers and syndicators. Carey has a strong track record of helping clients build and retain capital by leveraging tax- and cost-saving strategies and employing tax credits and incentives. He also consults with high net worth individuals, large family groups, and owners of closely-held businesses on all aspects of tax planning, estate planning, and retirement planning.
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