The interaction of complex tax rules for vacation homes has created a lot of confusion related to the eligibility of vacation homes for §1031 exchanges. There is no definitive rule in the Code or Regulations, therefore an analysis of the tax rules for vacation homes must be made and a conclusion drawn from this analysis.

Real estate qualifies for §1031 treatment only if it is held for productive use in a trade or business or held for investment. The test applies at the time of the exchange and applies to both the Relinquished Property and the Replacement Property. Section 1031 is very clear—real estate held for personal use and dealer property does not qualify as like-kind. IRS Publication 544 on Nontaxable Exchanges states:

“The property must be business or investment property. Both the property you trade and receive must be held for business or investment purposes. Neither may be used for personal purposes, such as your home or family car.”

Enter the vacation home. Is it property held for personal use and not qualified? Or is treated as real estate held for investment and therefore qualified? The question of whether real estate is held primarily for sale, or use in a trade or business, or for investment is a matter a factual determination in each case. Property held for personal use does not qualify as either business or investment property. It is treated as an asset “not held for profit.” In almost all cases, the term “vacation home” means a dwelling unit used for personal use but also rented out at fair market rent some time during the year.

Under the rules of §280, a dwelling unit held for both personal use and rental purposes must take a use test each tax year to determine its tax classification for that tax year: The property is treated as real estate held primarily for personal use and treated as an asset not held for profit if the owner's personal use is more than 14 days or 10% of the total rental days, and the unit is rented for one day or more during the tax year. The property is treated as rental property if the owner's personal use is no more than 14 days or 10% of the rental days during the tax year and the property is rented more than 14 days during the tax year.

The use test must be made every tax year for every vacation home. This test will determine the classification of the property that year for purposes of applying the various tax rules. For example, if the property is treated as personal use property with rental income, the loss limitation rules will apply and any operating loss deduction is denied. Deductions are limited to the gross rental income. If the property is treated as a rental property with personal use, the personal use deductions are disallowed but if there is an operating loss after applying the deductible rental expenses against the gross rental income, the loss is deductible as a passive loss rental activity.

Some writers have taken the position that a vacation home is investment property because it is not your primary residence. I disagree with this position. After a careful analysis and review of existing tax laws and regulations, I am of the opinion that if the property is classified as a vacation home in the year of exchange, it will not qualify for §1031 treatment. However, if the dwelling unit is an incidental part of a large land holding, it may be possible to “carve out” most of the land and treat it as investment real estate, leaving the dwelling unit and associated land as personal use property.

If the property is classified as rental property in the year of the exchange, it can qualify for §1031 treatment. Of course the question now is, “How long do I have to hold it as rental property?” The Code and Regs are silent on this issue. However, IRS Letter Ruling 8429039 permitted an exchange where the taxpayer said the Replacement Property (a residence) would be held as rental property for at least two years. The IRS said the two-year period was sufficient to ensure the residence to be acquired would meet the holding period prescribed by §1031.

Caution - Be very careful of self-serving reclassifications. A sharp IRS examiner will disallow an exchange if the property has been treated as a vacation home for many years, but you avoid using it for personal use for a few months into the new tax year so you can exchange it without recognition of gain. Again, this is one of those times to call your tax professional.