The National Flood Insurance Program (NFIP) is up for a vote again, and this insurance provides important affordable coverage for people in many areas of the Seattle / Puget Sound region. Most home owner insurance policies do not cover flood damage, and many home owners are not even aware that they have no coverage in this area. The NFIP covers obvious areas such as rivers overflowing their banks into property, yet many people also don’t know that it includes high tidal/wave action on the Sound, land movement due to heavy rains, mudslides, and related catastrophes that could potentially destroy a home and yet not be covered by the home’s regular insurance. With our area’s huge expanses of Sound and lake coastline, and our steep terrain with homes perched on fragile hillsides to maximize views, this can be important insurance for many home owners in many different locations.

The Federal Emergency Management Agency (FEMA) Mitigation Division manages the program, and it is federally subsidized so the rates are lower than would otherwise be available through private insurance (though of course there is the hidden generalized cost in our taxes to pay for the subsidy). Private insurers have been steering away from flood insurance over the years. Many high risk areas do not even have realistic private flood insurance options, and NFIP fills the void.

The legislation under consideration this week is HR 3121 Flood Insurance Reform and Modernization Act of 2007. This resolution extends the program for 5 years, increases coverage limits and inclusions, adds optional wind coverage, and other items. If this is of interest to you and your community, I recommend calling your Congressperson and expressing support. Later this year the Senate Committee on Banking, Housing and Urban Affairs will be creating its own NFIP reform bill as well.

1031 tax deferred exchanges, which allow the owner of an investment property to roll over gains into another “similar” investment property without paying taxes on the gains, can include personal vacation homes. However, the personal use of a vacation home must officially be restricted, usually keeping personal use to under 14 days a year or less than 10% of the time it is rented out.

There have been recent court cases clarifying the allowable personal usage of vacation homes, and what distinguishes between allowable and non-allowable properties for making a 1031 exchange at time of sale. A recent sale and 1031 exchange of a lakefront second home for another larger waterfront home tested some of these boundaries, and clarified some rules on the matter.

In general, there are several important aspects that a vacation home owner can do to demonstrate both intent and actual practice of maintaining a property for investment purposes. This includes: renting the property out and claiming the income, tracking expenses, depreciating the asset, deducting mortgage interest as an investment expense instead of a second home tax deduction, type of tax filings, and number of days of personal usage. Also, a property that is initially used mostly for personal use may be transitioned gradually over more to investment/rental use for a period prior to sale, and this could help justify a case that it was an investment property eligible for a 1031 tax deferred exchange. This is somewhat untested in the courts but some experts feel it could work if an exchange were questioned by the IRS.

There is likely an unexplored gray area between “personal usage” and “onsite maintaining of the property to uphold the investment value”. If you are onsite for the purpose of maintaining and inspecting the property, then likely it would be beneficial to document this with receipts (from the hardware store or such) and a simple log of activities.

It is important to note that the IRS does not accept just market value appreciation of the property to be a valid justification for establishing a vacation home as an investment property. The IRS recognizes that a property can be left on its own for appreciation, but if it is used for personal purposes then it must be treated as investment property via intent and practice as discussed above, even if part of that does not include rental income.

There are a lot of options out there for people who already have a vacation home – or else want to purchase a second/vacation home – and would like to enjoy the benefits of rolling up their gains via a 1031 tax deferred exchange. This is especially the case for people who don’t visit the property frequently and who also do advance accounting and tax planning practices in line with investment property approaches. Lots there to talk to your tax and legal advisors about, but very intriguing…