You’ve Got Some ‘Splaining to Do!

In the hit show I Love Lucy, Ricky Ricardo was known for saying “Lucy, you’ve got some ‘splaining to do!” in his memorable Cuban accent. With 1031 exchanges the ‘splaining is done by substantiating your tax positions with other financial and Tax documents. The best case of substantiating comes with residential rental property, a subject we want to address before Memorial Day in honor of summer.

The Tax Court recently ruled the sale of a vacation home and the purchase of another via 1031 exchange ineligible because the homes were not held for investment (Moore, TC Memo 2007-134). It is common knowledge that for a property to qualify for a 1031 exchange it must be held for investment. The problem in this case was that the taxpayer believed “investment” constituted buying a house and waiting for it to appreciate for eventual sale. The house was not rented out (nor was any attempt made to do so) and used for personal purposes only.

The facts of the case don’t make it any prettier. The taxpayer purchased this second/vacation home three hours away from his residence. The property was utilized for recreational purposes a few times a month until Labor Day, and then closed until the following spring. During the off months, the taxpayer would occasionally visit the property in the role of caretaker.

After moving his primary residence further away, the property fell into disuse and became run down. The decision was made to purchase a closer vacation home and treat the transaction like a 1031 exchange. Obviously the property was used only when wanted and convenience played a large factor. Typically, not how investments, especially ones you hope will appreciate, are treated. However, the kicker was that on his tax return he listed the properties deductions for “home mortgage interest” instead of “investment interest” and did not deduct depreciation, maintenance or other expenses.

Therefore taxpayers are left with “breadcrumbs” to follow regarding property that has both personal and rental use present. Taxpayers should (a) hold the property out for rent and have the listings; (b) declare the income as rental income; (c) take on offsetting depreciation deduction; (d) take a deduction for investment interest expense, (e) try to keep purely personal below 14 days a year.