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IRS Issues Vacation Home Ruling

Written by Gary Gorman on Wednesday, 05 March 2008 6:00 pm
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The IRS has just issued a new ruling that sets forth the guidelines for those taxpayers that wish to do a 1031 exchange involving a vacation home. By way of background, you can only exchange property held for investment or used in a trade or business. Up until last year there was no guidance from the IRS that said whether vacation homes were investment or personal use property, but that changed when the U.S. Tax Court disallowed a taxpayer's exchange from one vacation home into another. The court case immediately gave rise to the question of what has to be done to qualify a vacation home for a 1031 exchange -- this ruling is the IRS attempt to answer that question.

The ruling was released as a Revenue Procedure, which is a type of "cook book" ruling -- it sets out what a taxpayer must do to achieve a certain result from the IRS -- in this case the result is a promise from them that they will not dispute the investment nature of your vacation home.

So what do you have to do to achieve this result? First, the ruling imposes a 24 month holding period, for the Old Property if that is your vacation home, or the New Property if you intend to buy a vacation home, or for both if you're moving from one vacation home to another.

For each 12 month block of this holding period you must have rented the vacation home for at least 14 days at a fair market rent. Also during each 12 month block, the owner is only allowed to use the property for the greater of 14 days or 10 percent of the days rented. This means that if you rented the property for 30 days that year, you could still use it for 14 days, but if you rented it for 200 you could use it for 20. Days that relatives use the unit, presumably for free, count against you (although I have to believe that will not be the case if they pay a fair rent).

Although not specifically discussed in the ruling, you are allowed a reasonable number of "maintenance days" to care for the unit. These days need to be reasonable -- even the IRS knows that it doesn't take a week to shampoo the carpets.

So what happens if you don't meet the test? Before you slit your wrist, just remember: this is a safe harbor ruling -- it doesn't mean that your exchange is toast if you fail, and it doesn't mean that they will automatically audit you (although you can expect closer scrutiny if you do get audited).

Some of you have never rented, or tried to rent, your unit, and some of you have used it two or three or four months a year the last few years; this ruling is probably the death knell for your exchange. Most of our clients, however, actually come amazingly close to meeting it. My advice to all of you is to tighten up your record keeping and your tax reporting of your property (see my RealtyTimes article of February 4, 2008 for how I handle my vacation property). Be serious in your rental attempts; charge family members the going rental rate when they use it. Keep detailed records of the dates you use it and what you did - especially for each maintenance day. Your success at doing an exchange could very well come down to how good your records are.

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