Defer TAXES

Question: Can one defer capital gain taxes on the sale of a vacation home?

Answer: Yes, quite possibly. It now (2007) seems dependent on your intent at the time of sale. Proactive planning can help position your property and transaction better for a future tax-deferred exchange structure.

To exchange a vacation home for other real estate, the crucial question to ask is:

At the date of the exchange, is the vacation home primarily for personal use, or is it being held primarily for investment purposes (i.e. for future appreciation or for rental purposes)?

Exchanging out of a vacation property or second home ("relinquished property") and into a qualifying investment property or another vacation property ("like-kind replacement property") on a tax-deferred basis using a 1031 exchange was thought by some to be possible based on a Private Letter Ruling (PLR 1981-03117) issued by the Internal Revenue Service in 1981.

However, there was extensive disagreement among professional tax and legal advisors and 1031 exchange Qualified Intermediaries as to whether real property held and used for personal use and enjoyment such as vacation properties or second homes could be exchanged for other qualifying investment properties on a tax-deferred basis pursuant to Section 1031 of the Internal Revenue Code.

It has always been our position that 1031 exchanges of properties intended to be held solely for personal use and enjoyment would not qualify as property held for investment, and that any 1031 exchange of these vacation properties would be disqualified under audit.

The income tax issue in question centers around whether the vacation properties or second homes can be characterized as qualified use properties that have been held, reported and treated as qualified investment properties or whether the properties have merely been held and used for personal use and enjoyment and therefore would not qualify for tax-deferred exchange treatment.

PLR 198103117 was issued by the Internal Revenue Service in 1981. PLRs that are more than 20 years old should be reviewed and analyzed carefully to determine whether they are still relevant and/or whether the Internal Revenue Service has issued any subsequent rulings that are contrary to the IRS's original position in the PLR.

This PLR was also issued well before the final Deferred Exchange Regulations were issued in 1991, and the Deferred Exchange Regulations are very specific about exchanging qualified investment property for like-kind qualified investment property.

Prior to the recent Tax Court Memorandum we had to wonder whether the position contained within the PLR was still relevant and valid or whether the IRS's position had changed with the issuance of the final Deferred Exchange Regulations.

In addition, you should be aware that Private Letter Rulings are requested by and therefore issued only to specific individual taxpayers, and the PLR therefore can only be relied upon by the specific taxpayer that it was issued to. The rest of us can use the PLRs for guidance but can not rely upon any specific PLR as precedent.

It appeared that the 1981 PLR would permit the exchange of vacation properties held for personal use and enjoyment if the vacation property was also held for investment. However, the Deferred Exchange Regulations issued in 1991, approximately ten years after the PLR, seemed to contradict the position held in the PLR. There was no other guidance available from the IRS to help clarify this issue; until now.

Tax Court Memorandum 2007-134 (TCM 2007-134) was filed May 30, 2007, which provided an opinion on whether an exchange of vacation property held for personal use and enjoyment would qualify for tax-deferred exchange treatment. The TCM holds that this particular 1031 exchange did not qualify for 1031 exchange treatment because the taxpayer's real intent was to acquire, hold and use the property for personal use and enjoyment and not for investment purposes.

We now know based on Tax Court Memorandum 2007-134 that the primary intent of the taxpayer is what determines whether a property was held for personal use and enjoyment or whether it was held for investment purposes regardless of whether a secondary intent was present.

It also appears that your intent at the time of the disposition (sale) of your real property is the key issue in determining whether your intent was to hold for personal use and enjoyment or for investment and your original intent at the time that you originally acquired your real property is not relevent. E.g., Bolker v. Commissioner, 81 T.C. 782, 804 (1983), affd. 760 F.2d 1039 (9th Cir. 1985)

Property acquired with the intent to hold, use and treat as vacation property (personal use and enjoyment) will therefore not qualify for tax-deferred exchange treatment even if a secondary intent to hold for investment exists.

The issuance of the Tax Court Memorandum has helped clarify the issue of exchanging vacation properties held for personal use and enjoyment, but the TC Memo does still leave some questions unanswered.

It would appear that you could change your intent from holding for personal use and enjoyment to holding for investment purposes in order to complete a 1031 exchange. You would most likely want to hold the property for investment purposes for at least 12 to 18 months in order to demonstrate that you did in fact have the intent to hold for investment in order to qualify for tax-deferred exchange treatment at the time of disposition (sale).

You must carefully analyze and evaluate each of your transactions on a case-by-case basis with your legal and tax advisors to determine if your specific fact pattern would support a position that your vacation property or second home was in fact held for investment and would therefore qualify for tax-deferred exchange treatment.

Certainly, the more rental, investment or business use activity the stronger your argument will be that you had the intent to hold for investment. The more proof you have that the property was held, treated and reported as investment property, the better your position will be for a tax-deferred exchange. The more personal use, the weaker your argument. Proactive planning can help position your property and transaction better for a future tax-deferred exchange structure as well.

Deferring Capital Gains: 1031/LIKE-KIND EXCHANGES