Colorado Real Estate Journal - September 2, 2015
The Rocky Mountain region is hot right now and many of our beautiful Colorado resort areas are experiencing a strong increase in appreciation and sales activity. Real estate in resort or vacation destinations can produce diverse and significant tax consequences. These tax consequences 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 disposing of such property. Tax treatment at disposition. Qualifying for a 1031 exchange. Internal Revenue Code Section 1031 may be available for vacation property 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 primarily “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 Revenue Procedure 2008-16. Rev. Proc. 2008-16 creates a “safe harbor” for exchanges of vacation property; in other words, if the specified ownership 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, apartment, condominium, or similar improvement that provides basic living accommodations, which include a sleeping space, bathroom and cooking facilities (e.g., a residential property). 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 property if: 1) The relinquished property is owned by the property owner for at least 24 months immediately 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 greater of: 14 days, or 10 percent of the number of days the dwelling is rented out. Rev. Proc. 2008-16 discusses Barry E. Moore v. Commissioner, T.C. Memo. 2007- 134, a 2007 Tax Court decision, which provides a good example of what will not qualify for a 1031 exchange of a vacation 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 qualified 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 personal use and enjoyment. In reaching this conclusion, the court considered that: (i) the property owners never rented or attempted to rent the property 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 maintenance 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 requirements 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 evaluating 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 investment interest expense or business expense? Are the property improvements eligible for depreciation? Is the property used substantially as a personal 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. 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 primarily for investment. There are a number of steps that can be taken to accomplish this, which may include some of the following 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 property 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, vacationrentals.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 knowledgeable legal and/or tax adviser before engaging in a Section 1031 exchange. A careful review of a property owner’s unique facts and circumstances regarding his ownership, use and tax treatment of a vacation 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 intermediary to review the other 1031 exchange requirements and the 45-/180-day time deadlines well in advance of closing.