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Section 1031 requires that both the relinquished and the replacement properties be "held for productive use in a trade or business or for investment." The question about whether a property qualifies for 1031 treatment arises when a property that may be a rental is also used as a vacation home from time to time. With the equity appreciation in vacation properties, there has been a great deal of discussion about whether a home used for vacation purposes can be classified as "investment property."
To ensure Section 1031 exchange eligibility, the most conservative approach is to restrict personal use to the lesser of 14 days or 10% of the days the property was rented. Should the taxpayer take this approach and should the property earn an income, the IRS should be satisfied. If the property is not income producing and used in excess of 14 days a year for vacation use, then the IRS may find that the property was not an "investment".
Let's assume that we have a property that has earned no rentals and was used for vacation use. Could it still be considered a property eligible for a 1031 exchange? Some experts would argue that whether a property can be defined for investment strongly depends on the taxpayer's intent when the property was purchased. If the taxpayer intended to purchase the property as an investment due to the potential appreciation alone but never intended for it to be used for rental, they might decide to defend that position should the IRS ever audit the exchange.
In 2004, the United States Tax Court, the highest ranking tax court, issued a summary opinion, Rivera v. Commissioner, which addresses the issue of whether a vacation property can be an "investment" property. The case did not deal with a 1031 exchange but rather addressed deduction made on an investment property. Because the case was issued as a summary opinion, it will not have precedent setting authority under IRS Code Section 7463(b); however, the opinion gives a great example of how the tax court will analyze the issue of what constitutes an investment property. The case involved a vacation home in Lake Tahoe. The owners did rent the property out from time to time and testified that they did not violate the 14-day or 10% rule. The key testimony cited by the court was that the taxpayer purchased the property with the intention that it was an investment property. The fact that the property did not earn a profit or even have substantial rentals did not change the court's decision that the property was indeed held as an "investment". The court also made a point of saying that, although the property did not turn a profit, the property appreciated as an investment. Intent plays a large role in the court's decision. It is clear that the more intent that can be established by the taxpayer at the time of purchase and thereafter, the better.
There are four issues that should be considered in determining whether you will be successful in defending an audit of a 1031 exchange on a property that was used, to some extent, for vacation use.
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