March 05, 2009
In July, 2007, I wrote a brief article regarding the ability of the owner of a vacation home to dispose of the property by means of a like kind exchange of properties under Section 1031 of the Internal Revenue Code. The article concluded that in order to qualify for exchange, a property must not have been occupied for personal use by the owner and his family for more than the greater of fourteen days or ten percent of the days during which the property was rented to persons other than family members for a fair market rental. The article cited Moore v. Commissioner, TC Memo 2007-134, which held that an exchange property must be held primarily for investment in order to qualify as an exchange property under Section 1031, citing Montgomery v. Commissioner, T.C. Memo 1997-279 and Starker v. United States, 602 F.2d 1341 (9th Cir. 1979).
In February, 2008, the Internal Revenue Service issued Rev. Proc. 2008-16, 2008 IRB 547, which provides a safe harbor that, when satisfied, assures a party to an exchange that the requirement in Section 1031(a)(1) that the an exchange property be held for productive use in a trade or business or for investment has been satisfied. One of the requirements of the safe harbor is that, during the each of the two twelve month periods immediately before and after the exchange, the Owner and his family must not have used either the relinquished property or the acquired property for more than the greater of fourteen days or ten percent of the days during which the property was rented at a fair market rental to persons other than family members. This is the same as the test in Section 280A(d)(1) of the Code, which establishes a safe harbor for the deductibility of expenses other than interest and taxes incurred by owners of vacation homes. A second requirement of the safe harbor in Rev. Proc. 2008-16 is that the relinquished and acquired properties must be rented respectively to persons other than family members at a fair market rent for fourteen days or more during each of the two twelve month periods immediately before and after the exchange.
The safe harbor is helpful but will not provide assurance to families who wish to use the property for more than the periods allowed under Rev. Proc. 2008-16 or accept limited use for two years before and after the closing of the exchange. These owners will have to fall back on the test set forth in the Moore case, which is that the primary purpose for which the property to be exchanged was acquired and held was as a rental property. There is not a great deal of helpful authority either in the case law or in the form of rulings[1] to provide guidance to such owners. What is clear is that the argument advanced by the taxpayers in Moore, that they purchased the homes involved in the exchange with the expectation that they would appreciate in value and eventually be sold at a profit in the future, will not by itself suffice.
The Moore court cited just two cases that involved claims for deferral of tax under Section 1031 in connection with an exchange. In Starker v. Commissioner, 602 F2.d 1341 (9th Cir. 1979), the taxpayer neither acquired the home at issue (he directed that it be conveyed directly to his daughter) nor used it for any purpose other than as a personal residence. The court stated that the use of property solely as a personal residence was antithetical to its being held for investment. In Montgomery v. Commissioner, T.C. Memo 1997-279, the taxpayers claimed they had acquired a Lincoln automobile in exchange for a tractor-trailer. The court found that they had "exchanged a tractor-trailer which they did not own for an automobile they did not own," which clearly precluded a successful exchange. The court also observed that the taxpayers had failed to provide any records to support their claim that the car was used for business purposes or to testify to that effect at trial and stated that each of the property transferred and the property acquired must be held primarily for productive use in a trade or business or for investment in order to qualify as an exchange property under Section 1031(a)(1). Thus, neither case provides any guidance regarding the extent of the rental use to which property must be put in order to qualify for a tax deferred exchange.
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The remaining cases cited by the Moore court were decided under other sections of the Code, including Section 212(2), which allows a deduction for funds expended for the management, conservation or maintenance of property held for the production of income, which the court said must be determined by the same factual inquiry as Section 1031 - whether property has been held for investment. Only two of the cases cited involved properties that had been rented to persons other than family members.
In Jasinowski v. Commissioner, 66 T.C. 312 (1976), the taxpayers had acquired the property in question from a friend subject to a mortgage that had a principal balance substantially less than the value of the property and leased it back to her for seven years for a minimal rent that resulted in an annual loss. The taxpayers argued that they accepted title to the property with the expectation of a substantial future profit and would not otherwise have acquired the property. The court analyzed the matter under Section 183, which precludes the deduction of expenses for activities not engaged in for profit.[2] The court focused entirely on the annual losses during the years in question and held that the taxpayers did not have the requisite profit motive. Because Section 183(c) refers to Section 212 to determine whether property has been acquired and used for profit, the test under Section 183 would be the same as under Section 1031 in the view of the Moore court. Given the substantial value of the property in excess of the mortgage to which it was subject when the taxpayers acquired the property and the likelihood that it would eventually be sold at a profit, this decision seems questionable. In any event the case is not helpful to determine how much rental use is necessary to qualify a property for a Section 1031 exchange.
We are left with Gettler v. Commissioner, T.C. Memo 1975 TC Memo 87, which provides some guidance that is not favorable to taxpayers. In Gettler, the taxpayer purchased a villa in Acapulco in 1960, which he occupied for personal use from just before Christmas each year through January 15 and in August. The villa was available for rent during the rest of the year. He also set aside two weeks in the summer and in November for use by friends. It is not clear whether he charged a fair market rent for this use. Between 1961 and 1969 he made a small profit in two of these years and suffered losses that ranged from $2,142 to $5,360 during the remaining seven years. He personally managed the rental of the property. Marketing efforts included advertisements in the Wall Street Journal in three of the nine years and brochures that he prepared and mailed to potential lessees. He did not list the property with a rental agent in Acapulco or in Cincinnati, where he lived, relying primarily on referrals from prior lessees and an acquaintance. The court held that the property was held primarily for recreation and disallowed claimed deductions under Section 162 of the Code, holding that the property was not used in a trade or business. Apparently, the taxpayer did not make a claim under Section 212. The guidance provided by this case is rendered less helpful because, to qualify as a trade or business under Section 162, an activity must be considerable as well as regular and continuous.[3] This appears to be a more stringent standard than the test for deductibility under Section 212.
The difficulty involved in determining whether a property meets the standard set in Moore is compounded by the subjective nature of the test under Section 212. As described by the Jasinowski court, the lack of a profit does not by itself negate the presence of a profit motive; it is only evidence to be considered. Rather the court must consider all of the facts in making its determination. One standard that should be considered is found in Section 280A, Sections (c)(3) and (5). Although a taxpayer uses a vacation home for more than the test periods set forth in Section 280A(d)(1) as set forth above, he or she may still deduct operating expenses other than interest and taxes to the extent that, together with those expenses, they do not exceed the excess of the gross revenues from the rental use of the property during the taxable year over the sum of (i) the deductions allocable to the rental use which are allowable without regard to the use of the property by the taxpayer[4] and (ii) the deductions allocable to the rental use of the property by persons other than family.[5] If all or most of the operating deductions other than interest and taxes are barred under this standard, it appears unlikely that a vacation home will qualify as an exchange property.
If a vacation home does generate sufficient rental income to satisfy the test set forth in Section 280A(c)(5) for the deduction of all or most of its operating expenses other than mortgage interest and real estate taxes, it appears that a strong argument can be made that the home will qualify as an exchange property under Section 1031; however, because of the potentially dismal consequences of a failed Section 1031 exchange where the relinquished property has a substantial built in gain (which is generally the prime motivation to undertake a like kind exchange in the first place), your author would still hesitate enter into an exchange that does not satisfy the safe harbor in Rev. Proc. 2008-16 without better authority than is available than at present.
To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding U.S. tax penalties.
[1] Neither Rev. Rul. 59-229, 1959-2 C.B. 180 nor Rev. Proc. 2005-14, I.R.B. 2005-7, cited in Rev. Proc. 2008-16, involved a rental property.
[2] Commonly referred to as the "hobby loss" provision.
[3] Pinchot v Commissioner, 113 F.2d 718 (2nd Cir. 1940)
[4] Mortgage interest and taxes.
[5] Operating expenses other than mortgage interest and taxes. See Prop. Reg. §1.280A-3(d)(3).
Stuart T. Freeland represents businesses and institutions both as outside general counsel and in a broad range of transactions, particularly real estate related activities. His clients include a major Boston area university, real estate development firms and organizations involved in a variety of business activities. Mr. Freeland assists clients to organize and operate their businesses in a tax efficient manner.