Is Your Vacation Home Also an Investment?

When seeking to defer taxes on a real-estate venture by putting proceeds toward a new deal, make sure you can prove the property is an investment.
By: JANE HODGES: The Wall Street Journal Online
Editor's note: Owner's Manual is a new biweekly Q&A column on RealEstateJournal.com. Send your questions about managing your second home to RealEstateJournal@wsj.com.

Question: Can my wife and I use a 1031 exchange to buy a vacation home? If so, what limitations or rules govern that process?

- John Cameron, Seattle

John: Well, the short answer is "yes, but...." A 1031 exchange, named for a section of the Internal Revenue Service code, is a transaction designed for investment properties that allows investors to defer taxes when selling an investment property to acquire one of equal or higher value. If you follow the basic rules for a 1031 exchange and intend to use the property primarily as an investment, you should be fine. (Read the article: "Avoid These Errors in 1031 Exchanges."

The reason for the "but" is the challenge in proving vacation homes are an investment on the basis of appreciation alone. This is tricky territory because vacation-home owners often buy their property for both personal use and investment purposes. I spoke to an accountant and a lawyer, who had different takes on whether a vacation home that isn't rented would qualify as an investment for a 1031 transaction. Both say that IRS language on this topic is open to interpretation.

Gary Gorman, a certified public accountant and managing partner of 1031 Exchange Experts, a firm in Denver, says if you don't want to lease the property and plan to hold it for potential price appreciation, you can send a certified letter to your accountant, lawyer or a third party who aided in the exchange transaction. In the letter, state that the property you are acquiring is an investment because you expect it to increase in value. If the IRS later questions the legitimacy of the purchase, you have documentation. There have been recent tax-court cases in which 1031 buyers have successfully substantiated their vacation-home buys as investments, Mr. Gorman says. He adds that generally only a minority of people can afford to hold an investment home without renting it, so if you're like most second-home owners and rent your place, this question should not be a problem.

However, another 1031-exchange facilitator I spoke to, Pat Dowdall, a lawyer and managing director of the Atlantic Exchange Co. in Boston, says he doesn't recommend holding 1031 vacation property for appreciation alone. He says you should always try to rent the property to prove it's an investment. "The more rental activity the better," he says.

Both experts say that if you rent out the property you generally should qualify for 1031 status, even if you don't deduct the property as an investment on your taxes. Under IRS rules, if you use the home for fewer than 14 days or less than 10% of the time others rent it, then for tax-deduction purposes, the property counts as an investment. This kind of reporting on your tax return can bolster your 1031 investment claim. (If you don't meet that ratio, your tax deductions may be limited, but for 1031 purposes, both Mr. Dowdall and Mr. Gorman say rental activity supports the property's investment status.)

Going back to that gray area -- an unrented vacation home -- Mr. Gorman says many second-home owners using 1031 exchanges who don't need rental income list their properties for rent as a protective measure, hoping no renters will bite. If you're in that boat, you must charge fair market rent -- but you can set restrictions that limit the pool of renters to...well, very few. For example, you can require no smoking, no pets, extra per-person fees for more than two people, full-fee deposits and even a review of audited personal financial statements (typically only a minority of wealthy individuals have these available). Mr. Dowdall and Mr. Gorman both say you may want to review your rental restrictions with an accountant to check whether they might raise flags with the IRS.

Ms. Hodges is a free-lance writer in Seattle. She answers questions about managing second homes in Owner's Manual. Please send your questions to RealEstateJournal@wsj.com.

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