Builders and Contractors Exchange
Weekly Bulletin: 26 Oct 2007
Potential Pitfalls In 1031 Tax Deferred Exchanges
Your accountant or attorney may have advised you recently of the benefits of doing a 1031 Tax Deferred Exchange (“1031”). 1031 transactions have become increasingly prevalent in the last several years and are no longer a vehicle simply for real estate professionals. A 1031 is an exchange of real property permitted under the Internal Revenue Code that allows an owner to trade one “like property” for another under very specific guidelines and defer paying income tax. For property to qualify for deferral under a 1031 it must be “held for productive use in a trade or business or for investment”. Historically, the rules were more relaxed so that someone not a dealer in real estate could hold property “for future realization of appreciation” and thereby satisfy the “held for investment” requirement.
An increasing number of taxpayers have tried to use their vacation homes (or second homes) as the investment property required under 1031s and have successfully done so for a number of years, by relying on a 1981 private letter ruling that indicated that exchange treatment was available where the taxpayer had acquired such property in hopes of future appreciation. Thus, taxpayers who personally used (but never received rental income for) their vacation properties were able to avail themselves to 1031s by simply asserting that they acquired and held their properties in hopes that they would increase in value.
However, a recent case, Moore v. The Commissioner, erodes away at this general principle regarding the impact of personal use on a second home. In Moore, a taxpayer who never received rental income during more than ten (10) years of ownership and treated the same as a second home by paying home mortgage interest deductions and taking no deductions for investment interest, maintenance or other expenses (to which they might be entitled if it were a business or investment property) were not able to avail themselves to a 1031. The court found that (i) the longstanding rule that exclusive use of the property by the owner as a residence contradicts any claim by him that the property is held for investment, and (ii) the mere hope that the property may be sold at a gain does not establish the requisite investment intent if a taxpayer uses the property as a second home.
In summary, if the Internal Revenue Service (“IRS”) (i) does not find evidence that the taxpayers used the property for the production of income and (ii) finds convincing evidence that the property was used as a vacation retreat, the IRS is not likely to find that the property is eligible for 1031 exchange treatment. Before proceeding with a 1031, it is strongly advised that you seek the advice of your tax and legal professionals so as to possibly avoid unanticipated tax consequences arising from the sale of your vacation home.
Questions?
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This article is meant to bring awareness to this topic and is not intended to be used as legal advice.