When contemplating an exchange, one of the most common questions real estate investors ask is: Will my mixed-use vacation property be eligible for an exchange? Fortunately, the answer to this question is “yes.”
Vacation homes that are partly used for personal reasons and partly as rental properties may be eligible as relinquished property, but certain conditions should be met. In order to give quality counsel, accountants who have clients with vacation homes need to be familiar with the provisions of Revenue Procedure 2008-16. In this document, the IRS spells out the conditions under which vacation homes may be eligible in a 1031 exchange.
Even if accountants don’t have the time to master the elements of Rev. Proc. 2008-16, they should at least understand its basic purpose. That way, they will be able to notify their clients about what this document entails and point them toward someone with expertise. If the provisions aren’t accounted for, clients may end up in court and face serious negative consequences. At a minimum, all accountants should be able to identify when this document applies and direct their clients toward effective counsel.
Before we dive into the specifics of Rev. Proc. 2008-16, it’s important to note that this document is not law. This is a common misunderstanding, even among professionals within the 1031 industry.
Instead, like other revenue procedures issued by the IRS, is a guideline intended to supplement the agency's interpretation of Section 1031. If taxpayers follow this procedure, the IRS will not challenge the vacation home’s eligibility as relinquished property. Abiding by this document will mean avoiding a legal challenge, but this doesn’t mean going outside the bounds of 2008-16 will necessarily result in a failed transaction.
Our Congress – and various congressionally appointed administrative agencies – creates law, and our courts help define the full meaning of it through their opinions. The IRS is an enforcement agency, designed to implement the tax code and collect taxes. In a legal sense, it is just like any other creditor or collection agency.
In our legal system, transactions come under scrutiny when a legal “issue," or a disputed requirement of a given law, arises. As we know, there are several essential requirements of Section 1031 that stem from its main paragraph. When a transaction is challenged in court, this means there is an argument that one of these essential requirements, or other supplementary requirements, hasn’t been satisfied.
What Rev. Proc. 2008-16 is saying is that the IRS will not challenge the “holding requirement” of Section 1031 if taxpayers follow its guidelines. The potential issue that could be presented by vacation homes is the holding requirement. That is, there could be a dispute over whether such property satisfies the requirement that relinquished property must be “held for” investment.
If taxpayers disobey Rev. Proc. 2008-16, the holding requirement may still be met, but the issue can only be resolved on a case-by-case basis. It is not a quantitative requirement, as we know, but a qualitative one, and it demands an individualized analysis by the court. The language and appearance of the procedure may seem authoritative, but accountants should be aware that it is not a set of strict rules.
Despite the confusion the above may seem to cause, the guidelines are straightforward: For vacation homes used as relinquished property, taxpayers should own the property for at least 24 months prior to the exchange. For replacement property to be used as a vacation home, it should also be held for a minimum of 24 months.
These ownership periods are referred to as “qualifying use” periods, which operate just before the exchange (for relinquished property) or just after it (for replacement property). In other words, if a taxpayer owns a relinquished property vacation home for five years, only the 24 months immediately preceding the exchange constitute the qualifying use period.
Taxpayers must rent the home at a fair market value for at least 14 days in each of the two 12-month time segments which make up the 24-month qualifying use period. Also, their personal use of the home cannot exceed the greater of 14 days or 10 percent of the total days the home is used as a rental during each 12-month segment. These guidelines apply to both relinquished and replacement property. Thus, the IRS is making it clear that the holding requirement will not be contested should these guidelines be observed.
Let’s look at a specific example so accountants will have a sense of what to look for. Suppose a client notifies you about his or her intention to perform an exchange for a vacation home. And suppose they mention they have have owned this property for three years. Only the two years leading up to the transaction will be relevant for purposes of Rev. Proc. 2008-16.
Now, your client informs you that during each of the two most recent 12-month segments, the property has been rented out for 200 days. Their personal use during the most recent segment was 18 days, and it was 15 days for the period before that one. If you’re only mildly acquainted with the topic, you could simply point your client toward an authority on the subject of vacation homes in 1031.
But, if you’ve mastered Rev. Proc. 2008-16, you’d be able to reassure your client that he or she will qualify for the safe harbor. This is because all of the guidelines have been met in this example. The taxpayer meets the ownership requirements and the investment requirements because the home was rented for more than 14 days in both segments. And the taxpayer meets the personal use restriction requirement because the use did not exceed 10 percent of the days rented out.
Few clients will expect their accountant to know the ins and outs of Rev. Proc. 2008-16 by heart, and it will go far toward improving client retention if you at least familiarize yourself with this document and its basic purpose.