Page 20AA —
COLORADO REAL ESTATE JOURNAL
— September 2-September 15, 2015
1031 Exchanges
T
he Rocky Mountain
region is hot right now
and many of our beau-
tiful Colorado resort areas are
experiencing a strong increase
in appreciation and sales activ-
ity. Real estate in resort or vaca-
tion destinations can produce
diverse and significant tax
consequences. These tax con-
sequences can be particularly
critical at the time a property
is sold as property owners may
be facing significant capital
gain tax consequences upon
disposition. The use of a 1031
tax-deferred exchange can be
particularly important in dis-
posing of such property.
n
Tax treatment at dispo-
sition.
Qualifying for a 1031
exchange. Internal Revenue
Code Section 1031 may be
available for vacation prop-
erty owners seeking to defer
capital gain taxes on the sale of
a vacation-type property. The
main issue, in most cases, is
whether the properties sought
to be exchanged are held pri-
marily “for the productive use
in a trade or business or for
investment,” or whether they
are held exclusively for the
personal use of the property
owner. The starting point in
addressing this issue is Rev-
enue Procedure 2008-16.
Rev. Proc. 2008-16 creates a
“safe harbor” for exchanges
of vacation property; in other
words, if the specified own-
ership and use requirements
of Rev. Proc. 2008-16 are met,
the property will qualify under
Section 1031. Under Rev. Proc.
2008-16, a “dwelling unit” is
defined as any real property
improved with a house, apart-
ment, condominium, or simi-
lar improvement that provides
basic living accommodations,
which include a sleeping space,
bathroom and cooking facili-
ties (e.g., a residential prop-
erty). The safe harbors for the
relinquished property and for
the replacement property are
substantially the same. The IRS
will not challenge whether a
relinquished dwelling unit, or
a replacement dwelling unit,
qualifies as Section 1031 prop-
erty if:
1) The relinquished property
is owned by the property owner
for at least 24 months immedi-
ately prior to the exchange,
or the replacement property is
owned for at least 24 months
immediately after the exchange
(the 24-month period, whether
for the relinquished property
or the replacement property, is
referred to as the “qualifying
use period”); and
2) Within each of the two
12-month periods that make
up the qualifying use period
(whether for the relinquished
property or the replacement
property): a) the property
owner rents the property to
another person or persons at a
fair rental for 14 or more days;
and b) the property owner’s
personal use of the dwelling
unit does not exceed the great-
er of: 14 days, or 10 percent of
the number of days the dwell-
ing is rented out.
Rev. Proc. 2008-16 discuss-
es Barry E.
Moore
v.
C o m m i s -
sioner, T.C.
Memo. 2007-
134, a 2007
Tax
Court
d e c i s i o n ,
which pro-
vides a good
example of
what
will
not qualify
for a 1031
e x c h a n g e
of a vaca-
tion property. In Moore, the
property owners exchanged a
lakefront vacation property for
another lakefront property. The
property owners argued that
both of these properties were
held for investment because
of the potential for long-term
appreciation, and thus quali-
fied for tax deferral under
Section 1031. However, the
court concluded that neither
property was held primarily
for investment purposes, but
was instead held for their per-
sonal use and enjoyment. In
reaching this conclusion, the
court considered that: (i) the
property owners never rented
or attempted to rent the prop-
erty to others; (ii) the property
owners deducted mortgage
interest as a “home mortgage
interest” expense rather than
investment interest expense;
and (iii) the property owners
did not take (and probably did
not qualify for) depreciation or
other tax benefits associated
with an investment property
including deductions for main-
tenance expenses.
Rev. Proc. 2008-16 provides
a safe harbor for qualifying
vacation homes for purposes
of Section 1031 and meeting
its requirements is the safest
approach. However, property
that does not meet the require-
ments of Rev. Proc. 2008-16 may
nevertheless qualify as like-
kind property under Section
1031. The key issue is whether
the property owner’s primary
intent is holding the property
for investment purposes (i.e.,
rental income) versus personal
use. There are a number of
factors to consider in evaluat-
ing a possible 1031 exchange
opportunity: Has the property
been shown on one or more
tax returns as an investment
property or property used in a
trade or business, including the
characterization of mortgage
interest as deductible invest-
ment interest expense or busi-
ness expense? Are the prop-
erty improvements eligible for
depreciation? Is the property
used substantially as a person-
al vacation property or second
home? The characterization of
residential property as held
primarily for investment or for
use in a trade or business is
often unclear, and dependent
upon the particular facts and
circumstances.
n
Converting a vacation
home into an investment
property.
A property owner
can prepare in advance for a
potential Section 1031 exchange
in the future by converting a
vacation home or second home
into a property held primar-
ily for investment. There are
a number of steps that can be
taken to accomplish this, which
may include some of the fol-
lowing actions:
• Keeping any personal use
of the property to a minimum,
under two weeks a year, and/
or below 10 percent of the days
the property is rented, if opting
to stay within the parameters
of Rev. Proc. 2008-16;
• Hiring a local proper-
ty management company to
make the property available for
rental use;
• Listing the property for
rental on popular websites
such as VRBO.com, rentals.
com, homeaway.com, vacation-
rentals.com, etc.; and
• Showing rental income
on Schedule E of the property
owner’s tax return and other
tax treatment consistent with a
rental investment property.
As always, it is important
to consult with a knowledge-
able legal and/or tax advis-
er before engaging in a Sec-
tion 1031 exchange. A careful
review of a property owner’s
unique facts and circumstances
regarding his ownership, use
and tax treatment of a vaca-
tion property should be done
before the decision is made to
proceed with a 1031 exchange.
It is also advisable to talk to a
reputable qualified intermedi-
ary to review the other 1031
exchange requirements and
the 45-/180-day time deadlines
well in advance of closing.
s
Erin Crowley
Division manager,
Asset Preservation
Inc., Denver
