In a 1031 exchange, no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment. But do vacation homes and rental properties satisfy those requirements?
Consider the Intent of the Owner
The relinquished property must be held for a qualifying purpose, e.g., investment / business. It has been said that one must have had the "intention" to hold the property for investment purposes at the time of the sale; and that it is the taxpayer's responsibility to demonstrate the requisite intent (to hold the property for productive use in a trade or business or for investment) at the time of the exchange.
In Rev Rul 57-244, 1957-1 CB 247, the IRS held that a residential property could be changed to qualified exchange property if the taxpayer actually altered or transformed the use of the property. However, simply renting out a personal residence will not automatically qualify it for tax-deferred exchange treatment.
Here is an excerpt from a tax treaties that is somewhat on point but deals more with the holding of the new replacement property:
The property received in the exchange must also be held for investment or in the taxpayer's trade or business. It is not clear how long such property must be held. The phrase "to be held for" in I.R.C. § 1031(a) implies a continuity of ownership. A subsequent disposition of the property received may be evidence that the property was not acquired for investment or use in the taxpayer's business.
What if the Property has Been Held a Very Short Time Before it is Exchanged?
For example, if X received a distribution of a building from a partnership and immediately exchanges it, has X met the "held for" requirement? See Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985), aff'g, 81 T.C. 782 (1983) (the court allowed a I.R.C. § 1031 exchange where the real estate transferred had just been received in connection with a liquidating distribution from a corporation); the court held that the requirement that the realty be held for investment was satisfied as it was not acquired in the liquidation with the intention of liquidating the realty or using it personally.
What if the Taxpayer Wishes to Conduct an Exchange Involving a Vacation House?
In Rev. Proc. 2008-1, C.B. 585, the IRS provides a safe harbor for whether a dwelling unit, including a vacation property, will be considered property held for productive use in a trade or business or for investment.
Please check with your CPA about the matter and if they would require additional rental history and tax reporting consistent with use as a rental property (rather than personal use).
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