When Can a Vacation Home Qualify for 1031 Exchange?

We frequently receive inquiries as to whether or not vacation properties qualify for exchanges. Section 1031 requires that both the relinquished and the replacement properties be “held for productive use in a trade or business or for investment.”

In the context of vacation properties, this “trade or business” or “investment” purpose may exist, but there may also be personal use of the property. When there is such a dual or mixed use, it is not always clear as to whether the property qualifies for Section 1031 purposes.

As a preliminary matter, it should be noted that neither the Code nor the regulations provide a definition of what is meant by “productive use in a trade or business” or by “investment.” Moreover, the Code  does not specify whether the trade or business use or investment status must be “exclusive,” “primary” or only “significant.”

We believe that mixed-use properties generally fall into one of four categories:

• Personal use segregation where there are multiple units;

• Personal use segregation in one unit;

• Properties w h o s e personal use meet the requirements of Section 280A; and

• Personal use in excess of the Section 280A

Limitations.

a. Multi-units: personal use segregation. The authorities are fairly clear on the “qualified use” implications of property that is used both in a trade or business and for personal purposes, where the bifurcation is spatial. For example, if the taxpayer occupies one unit in a three family home with the other two units rented, or owns an operating farm with his or her home on a portion of the property, allocations can be made between the business and personal residence portions of the property based on square footage, relative value or other reasonable bases.

b. One unit: personal use segregation. Personal use can be segregated even in a single residential  unit. For example, the IRS has recognized an allocation between personal residence and business use of a bed & breakfast home for purposes of allowing depreciation and other business-related deductions. See PLR 8732002.

Such an allocation should also apply for Section 1031 purposes. Other examples of a segregation of single residences are rooms used exclusively for offices or long-term lodging.

c. Section 280A requirements.

The next issue is whether any Section 1031 treatment may apply if the entire property has been put to both personal and business use. The general view is that the exchange will qualify if the requirements of Section 280A(d) are met. Under that provision, property is treated as business property (thereby allowing for depreciation deductions) or investment property (thereby allowing for losses on a sale) so long as the taxpayer’s personal use of the property does not exceed the greater of fourteen days or ten percent of the number of days that the property was rented at fair value to others.

For purpose of computing personal use, any time spent at the property for maintenance or other business related reasons are not to be counted against the taxpayer. Careful record keeping is recommended to qualify under Section 280A.

d. Don't meet Section 280A requirements. What if the personal use exceeds the limitations of Section 280A, but the property is rented for a portion of the year?

For example, assume that the property is rented for seventy percent of the year and used as a vacation home for thirty percent of the year.

Initially, it should be noted that the Section 280A analysis is nowhere explicitly made applicable to the Section 1031 “qualified use” requirement. It may be possible that

the requirement can be met even though the taxpayer has been present on the property for personal reasons for a greater number of days than Section 280A would ordinarily sanction. For example, the Service has ruled that some minor personal use of investment property should not render the property ineligible for a Section 1031 exchange if the relinquished and replacement properties are essentially investment

property. The question then is whether in the above example there could be a bifurcation to treat the property as qualifying for an exchange on a 70/30 basis. See generally Whitmire,

Planning Tax-Deferred Property Transactions, ¶ 2.02[2]

This approach, however, appears not to have been seriously considered by the courts or

the IRS and there is clearly a division of opinion among the experts.

Accordingly, taxpayers should seek advice in determining whether an exchange (or a partial exchange) is possible in these and related circumstances.

Conversion of mixed use or personal use property.

Finally, some of the foregoing issues can be simplified if a bona fide conversion of mixed use or exclusively personal use property is made. Effecting such a conversion is a matter of the facts and circumstances.