In a 1031, you defer the tax on the sale if the old property you are selling and the new one you’re buying are held for investment or used to produce income. Referred to as a “like kind” exchange, in real estate this refers to service or use of the property. For example, if you sell land, you don't have to buy just land. Any property is allowed if it's held for investment. Although confusing, one thing is clear: Real property held for personal use does not qualify, simply because it is not held for investment. So where does the vacation home fit into this?
By definition, vacation homes lend themselves to personal use. They are situated in vacation destinations away from your main home. Prone to warm weather or recreational uses, no mention of investment activity would lead a tax professional to declare it personal use.
What if you rented or tried to rent it when it was vacant, would it then qualify? Section 1031 does not define investment. In another code section, 280, it states if you use the property more than 14 days of the year or more than 10% of the time rented, then you cannot deduct the loss associated with operating the unit. Although there is no clear path between the two code sections, 1031 and 280, there is some indication the IRS tried to define investment activity within section 280, and may lean on it during an audit.
This is significant because the recent real estate boom created enormous gains for many real estate investors. Some exchanged their vacation properties for upgraded replacements; others now want to do the same. So how can you sell your vacation home and qualify it for a 1031 exchange?
Two recent tax court cases involving vacation homes provide guidance. The first, Rivera v. Commissioner (2004), the taxpayers used the property personally and never rented it. The court ruled for the taxpayer allowing the exchange based on testimony they purchased the property with the expectation it would increase in value. This argument satisfied the investment criteria of 1031 per the court.
In a more recent tax court ruling, Moore v. Commissioner (T.C. Memo 2007-134, 5/30/07), the taxpayers used the property personally over four months per year, sat vacant the rest, never rented it, and deducted personally all the expenses on their tax return. The taxpayer testified they bought the property with the expectation it would increase in value as in Rivera, but the court challenged and determined the property was held personally, disallowing the exchange. The court said if they handled the expenses differently on their tax return, they might have agreed. Therefore, how you handle your investment property’s expenses on your tax return may determine if your property qualifies as investment for 1031.
When documenting investment, the best indication is to actually rent or try to rent your property when it's vacant, and claim the income and expenses on your tax return. You can also send a letter to your CPA declaring the property to be mainly held as an investment and secondarily for personal use, and to handle it as investment property on your tax return. There are more methods you can employ, and in all cases discuss them with your CPA as he will be the one signing your return.