One of our friends inquired the other day as to whether he could exchange his Scottsdale vacation home in which he lived approximately 35 to 40% of the time for another investment property because he believed that home was “held for investment.” The question raises several issues, and unfortunately there are few clear answers.
Under Section 1031, qualifying property must be held either for productive use in a trade or business or for investment. The Treasury Regulations do not define “held for investment,” although they provide that unproductive real estate held by a non-dealer for future use or future appreciation is held for investment.
Vacation homes may qualify as investment property if personal use is minimal, or if the home is also rented for a portion of the year. It seems that property is not “held for investment” under Section 1031 if losses from a sale or exchange of the property cannot be deducted. Internal Revenue Code Section 280A governs the allowance of deductions (presumably including loss deductions) from a “dwelling unit” that the taxpayer uses as a residence, including a vacation home. Based on the language of several cases from the 9th Circuit Court of Appeals, Section 280A may also govern whether the home is held for investment under Section 1031.
Section 280A is quite restrictive. For instance, it provides that a taxpayer uses a dwelling unit as a residence if the taxpayer uses the dwelling unit for personal purposes for a number of days which exceeds the greater of 14 days or 10% of the number of days during the year for which such dwelling unit is rented for fair market value. Use by the taxpayer in excess of those time limits prevents the taxpayer from deducting losses.
If Section 280A does not apply to determine whether a vacation home is held for investment, then code section 165 should apply. The general rule under section 165 is that losses may be deducted if the transaction was entered into for a profit. A profitable sale must be the predominant motive and not the secondary motive.
Under either of these tests, a taxpayer who uses a vacation home more than incidentally during the taxable year of the exchange might not be holding it for investment for purposes of section 1031. The taxpayer will have to argue that the predominant motive in owning the vacation home is profit, not personal enjoyment. It is important to remember that the taxpayer has the burden of proof to show that the property was held for a qualifying use. Obviously, the more the vacation home is used by the taxpayer, the less it looks (to a judge, perhaps?) like a predominant profit motive.
In light of this, a taxpayer who is considering an exchange of an interest in a vacation home under section 1031 should, during the year of the exchange, not exceed the personal use limits of code section 280A, or should rent the property at fair rental at least during the year in which the exchange occurs, and preferably longer. As an alternative, a taxpayer who wants to defer gain on a vacation home might take advantage of the gain exclusion under code section 121 by converting the vacation home to the taxpayer’s principal residence for a sufficient period to qualify for that exclusion (two years of the five years before sale).
In the next newsletter, we will discuss the issues related to converting a vacation home to a qualifying use or converting qualifying use property to a vacation home.
