After a recent Tax Court ruling that disallowed one taxpayer's 1031 exchange of his vacation (or "second") home, I've seen articles on this topic that range from "this was a bad ruling, so ignore it," to "the sky is falling and you can no longer 1031 vacation homes under any circumstance."

by Gary Gorman founding partner, 1031 Exchange Experts, LLC

So can you exchange a vacation home? For those of you who are not familiar with this controversy, let me summarize the issue: Section 1031 allows the deferral of the gain from one investment property into another. Properties held strictly for personal enjoyment do not qualify. The question is, "Are vacation homes held for investment, or for personal enjoyment?” The Tax Court ruling clarified that vacation homes held strictly for personal enjoyment do not qualify. The trick then is to differentiate your property from purely personal enjoyment, and cast it, or document it, as investment property.

Here is what I'm doing on a vacation home I own: Since my property is in a complex where property management is not available, I use an on-line leasing service which has proven to be an effective way for me to manage the leasing of this property from a distance because it showcases my property very well -- so my site gets lots of hits.

“...Here is what I'm doing on a vacation home I own....”

I keep a copy of the inquiries, and my responses, in a separate email folder as a part of my Outlook file. This proves that I've sincerely tried to rent the property. I also keep a calendar of the dates that I use the property, and whether I used the property for enjoyment or for maintenance. I have a cleaning service that I use to clean the unit between renters, but periodically we like to go in and do deep cleaning ourselves. Also, I have a number of great clients in that city, and occasionally I'm there for meetings or to give a speech or a class, and I stay in the unit on those occasions.

My calendar, therefore, reflects the dates that I used the property and whether I used it for enjoyment, maintenance or business. I try to keep the enjoyment days to less than 14 days a year, and I make sure the maintenance days are reasonable because the IRS will allow you 14 personal enjoyment days, as well as a reasonable number of maintenance days a year. In my case I typically use the property for 10 to 14 personal days, two to four maintenance days, and 7 to 14 business days a year. The rest of the time it's either rented, or available for rent.

At the end of the year I file Schedule E for this property with my tax return. Schedule E is the form that reports income and expenses (including interest & taxes) from rental property. Don't deduct the interest and taxes for your vacation property on Schedule A of your tax return. Schedule A is the form you file to report personal deductions associated with your personal residence. The IRS is very formal about these things, and they assume that if the property were truly an investment property you would have filed Schedule E.

Make sure too that you are depreciating your property. Depreciation is required for rental property, but not allowed for personal enjoyment property. It's another one of those things that impacts how the IRS views the property.

I recommend that you have a separate bank account for your rental property -- actually I would prefer a separate account for each rental property. You don't want to run the income and expenses for your rental property through your personal check book.

If you want to exchange your property when you sell it, assume that you'll get audited, so do things correctly from the beginning. The difference between being able to do an exchange and deferring the tax, or having to pay tax on the sale of your vacation home depends upon your willingness to follow the steps I've laid out above.