June 20, 2005

Exchanges With Vacation Homes

Property does not qualify for non-recognition under Section 1031 unless it has been held for productive use in a trade or business or for investment.  Can a vacation home be “held for investment” under Section 1031, and if so, when?

Neither Section 1031 nor the Treasury Regulations that provide a safe harbor for a Deferred Exchange define “held for investment.”  Instead, to answer this question, we have to look at a patchwork of various authority that has come down over the years.

In Dewey v. Commissioner, TC Memo 1993-645, the Tax Court held that a two-week timeshare was not used for investment when used for vacation purposes by the taxpayer and family.

In a footnote to Sedar v. Commissioner, TC Memo 1986-504, n.13, the Court stated: “When property is purchased both to provide a residence for relatives, and for investment purposes, a loss from the sale or exchange of the property is deductible if it is held primarily for investment purposes.”

Thus, if losses cannot be deducted, a property is not “held for” investment.

Section 280A governs the allowances of deductions from a “dwelling unit” that the taxpayer uses as a residence, including a vacation home.  It may also govern whether the vacation home is held for investment under Section 1031.

Section 280A provides that a taxpayer uses a dwelling unit as a residence if the taxpayer uses the unit for personal purposes for a number of days that exceeds the greater of 14 days, or 10% of the number of days during the year for which such dwelling unit is rented for fair market value.

If Section 280A does not apply to determine if a vacation home is held for investment, then Section 165 may apply.  Under Section 165, losses may be deducted if the transaction were entered into for profit.

Section 280A provides a certain test for determining whether a vacation home is held as a business and deductions are allowed.  If a taxpayer uses a vacation home substantially, the taxpayer will probably be unable to use Section 280A to argue that he held the property for investment.  He will have to argue that his predominant motive is a profit motive under Section 165.  The more it is used by the taxpayer, the less likely he has a predominant profit motive.

Therefore, a taxpayer desiring to exchange an interest in a vacation home under Section 1031 should not exceed the personal use limits of Section 280A, and should probably rent the property at a fair rental value at least for the year leading up to the exchange.

If you have questions about this or any other area of concern about Section 1031 exchanges, please feel free to call.