We receive many questions about vacation homes, and specifically whether these properties may be exchanged under Internal Revenue Code §1031. Let’s dive into the issue.

In addition to selecting a second home often based on its proximity to sun and fun, most owners acquire a vacation home hoping they can eventually sell it at a profit. Vacation homes are also typically rented when not used by the owner, creating a revenue stream that can help pay the bills.

The Rev. Proc. 2008-16 safe harbor

In 2008, the IRS provided guidance to would-be vacation home exchangers by establishing a “safe harbor” for these transactions. Under Revenue Procedure 2008-16, a vacation home may be exchanged provided:

  • The relinquished property is owned by the taxpayer for at least 24 months prior to the exchange, and the replacement property is owned by the taxpayer for at least 24 months after the exchange (the “qualifying use period”); and
  • In each of the two 12-month periods in the qualifying use period, the taxpayer rents the property to another person for 14 or more days at a fair rental rate, and uses the property personally for no more than the greater of 14 days or 10% of the number of days it is rented at a fair rental rate.

Personal use includes use by a family member, unless the property is rented to the family member as their primary residence at a fair rental rate. See IRC §280A(2) and (3).

While vacation homes may be exchanged outside these guidelines, exchangers who comply with the requirements will have greater certainty that their exchange will be respected in the event of an audit.

When a vacation home does not qualify

Moore v. Commissioner, T.C. Memo. 2007-134, is a good example of a vacation home that did not qualify. The tax court sided with the IRS in disallowing the exchange, finding that the taxpayer never rented the properties and used them personally as much as two to three weekends per month during the spring and summer. The court also found that the taxpayer never took a deduction for investment mortgage interest (they instead deducted “home mortgage interest”) and did not deduct maintenance or other costs associated with the property.

The Moores also acquired their replacement property because it was closer to their new home, where they presumably would be able to use it more frequently. Given these facts, the court held that the mere expectation of appreciation was not sufficient to establish that the taxpayer’s primary purpose for holding the property was investment rather than personal use.

How the IRS would view vacation homes exchanged outside of the safe harbor would likely depend on the facts and circumstances. Owners should limit their personal use and maximize rental use as much as possible, particularly during the qualifying use periods before and after the exchange. There is a lot of ground between Moore and the safe harbor of Rev. Proc. 2008-16, so any taxpayer considering a 1031 exchange of a vacation home should consult with their tax adviser before structuring the transaction.