Caution Urged on Tax-Free Exchanges

We have seen a number of people run afoul of the rules on tax-free exchanges, especially with regard to vacation homes.  In general, Section 1031 of the tax code allows the tax-free exchange of business and investment properties without any income tax implications.  A qualified intermediary is necessary to effectively complete an exchange.  One or more replacement properties must be identified within 45 days of the closing on the relinquished property, and the closing on the replacement property must occur within 180 days of the sale of the relinquished property.

The definition of “like-kind” is fairly loose, e.g., a land investment can be exchanged for an apartment building.  However, one aspect is very clear: the exchanged properties must be for business or investment purposes.  Vacation homes are generally deemed to be personal property.  Even if a vacation home is held for a long time, such that one might consider it an “investment” property, the use of the vacation home is determinative. 

If the vacation home is used for recreational purposes and never rented out, the vacation home is clearly personal property – and therefore ineligible for a Section 1031 exchange.  The deduction of mortgage interest on Schedule A, Itemized Deductions, is also another sign that the property was used as personal property.  In summary, the acquisition of a vacation home with the prospect of appreciation in its value may prompt the purchase, but this factor alone does not transform the personal-use property into investment property.