Do vacation and second homes qualify for IRC §1031 treatment?

Vacation and second homes that are held by the Exchanger primarily for personal use do not qualify for tax deferred exchange treatment under IRC §1031. When vacation homes are used both for personal purposes and business purposes, the allocation between the uses becomes important. Obviously the greater the personal use, the less likely the second home will qualify for an exchange. IRC §280A provides that the personal use of a second home for more than 14 days a year characterizes it as a residence. Given the lack of guidance in this area, this 14-day rule has been applied as the standard of allowable personal use of property eligible for a §1031 exchange.

While an argument may be made that vacation homes should qualify as investment property, the argument is unlikely to prevail when the Exchanger’s intent is to use the property solely for personal use. However, when the Exchanger’s primary intent in purchasing a vacation home is investment, the fact that there is personal use does not exclusively recharacterize the Exchanger’s intent. Sedar v. C.I.R., T.C. memo 1986-504, (1986).

Taxpayers that use a vacation home for significant personal use may wish to qualify the home for a §1031 exchange based on the fact that their primary acquisition intent was for investment. For §1031, property is held for investment purposes if losses from the sale or exchange of such property are deductible.Starker v. U.S., 602 F.2nd 1341, 1350-1351 (9th Cir. 1979). Where an Exchanger established that his primary intent in acquiring the second home was to make a profit, the court allowed a business expense deduction under IRC §212 for an 11-month rental period despite personal use for the remaining month, allocated the deduction between investment and personal use. Rivera v. C.I.R., T.C. Summ. Op 2004-81(2004). However, Rivera may not be cited as legal precedent and there is no direct legal authority that either property used for significant personal use will qualify for a §1031 exchange because deductions were allowed under either IRC §208A or §212. Exchangers taking the position that a second home, or portion of a second home, qualifies for exchange treatment despite personal use because it was purchased predominantly for investment have a heavy burden of proof and should consult their tax advisor

An Exchanger may utilize a §1031 exchange to avoid paying capital gains tax on the sale of a vacation home by converting it to valid exchange property and establishing this intent by renting the property and holding it for the requisite period. See Rev. Rul. 57-244, 1957-1 CB.247. Revenue Procedure 2005-14 provides examples illustrating that if an Exchanger rented a primary residence for two years and claimed depreciation deductions, the house would qualify for exchange treatment. In each of the examples, it was assumed that the property had been used in the Exchanger’s trade or business or held for investment within the meaning of §1031.