| Your clients might own a getaway home in the country, a cozy cottage on a lakeshore, a condo on the oceanfront or a rustic cabin in the mountains. When they sell it, they may recognize gain without the benefit of the principal residence exclusion in IRC § 121. This prospect may make a section 1031 tax-deferred exchange an attractive option, particularly for highly appreciated property. But certain qualifying provisions have proven cloudy for tax practitioners, particularly when a dwelling is held for productive use in a trade or business or for investment, as section 1031(a)(1) requires, but is also used at least occasionally by the owner for personal purposes, such as vacation lodging. How much personal use is permissible? PRODUCTIVE USE IN BUSINESS OR AS INVESTMENT
The Tax Court has consistently held that an expectation of appreciation in value is not in itself sufficient to qualify a vacation home as held for investment, particularly if the taxpayer uses it as a secondary residence without renting it. Rather, the court has looked to the primary purpose of acquiring and holding the property (Moore v. Commissioner, TC Memo 2007-134). IRC § 280A addresses personal use in the context of deducting expenses of a bona fide rental or other use of the dwelling in a trade or business. A taxpayer who personally uses the dwelling more than the greater of either 14 days a year or 10% of the number of days during the year in which the dwelling unit is rented at fair market value is using the property as a residence and not as an investment. “Personal use” under this section includes not only use by the taxpayer but also by any member of the taxpayer’s family, or anyone who is a co-owner. It also includes use by any person under an agreement that enables the taxpayer to use some other dwelling (for instance, if they trade use of homes—whether or not the taxpayer pays rent on the other unit). Rental of the taxpayer’s dwelling for less than fair market value may also constitute personal use. SAFE HARBOR OUTLINED
Recently, the IRS adapted the personal-use standard of section 280A to fashion a safe harbor for purposes of section 1031 exchanges. Noting the “primary purpose” standard of Moore, the Service acknowledged in Revenue Procedure 2008-16 that “many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes.” In the revenue procedure, issued in February, the Service outlined conditions of limited personal use under which it will not challenge whether a dwelling unit qualifies under section 1031 as property held for investment or held for productive use in a trade or business: The relinquished and replacement dwellings must be owned by the taxpayer for at least two years immediately before (relinquished property) and immediately after (replacement property) the exchange. In addition, in each of those years, the dwellings must be rented to another person or persons for fair value for at least 14 days, and the personal use must not be more than that allowed under section 280A (the greater of 14 days or 10% of the number of days rented per year). Revenue Procedure 2008-16, which became effective March 10, 2008, would seem to clear the air on many of the foggy issues surrounding 1031 exchanges for vacation and second homes. That said, the taxpayer must still satisfy all of the other requirements for a like-kind exchange to qualify for tax-deferred treatment. They include, among other requirements, that the replacement property must be identified within 45 days after transfer of the relinquished property and the exchange completed by the earlier of either 180 days or the due date (including extensions) of the taxpayer’s return for the taxable year in which the relinquished property was transferred. Related persons who exchange property must hold it for at least two years following the last transfer.
GAINS RATE CHANGE POSSIBLE
The top long-term capital gains rate of 15% is currently scheduled to revert to 20% in 2011. This has been cited as a potential reason not to defer capital gains beyond that date (see “Property Investors Fear Gains-Tax Rise, Shift 1031 Strategy,” The Wall Street Journal, March 12, 2008). However, for many taxpayers who find deferral of gain from a real property sale in their best interest, a section 1031 exchange can be a viable strategy. For such clients, there’s now a clear answer whether they can spend a two-week vacation at their rental cabin without endangering a prospective exchange. By Stephen A. Wayner, Esq., a real estate attorney and Certified Exchange Specialist (CES) with more than 35 years of real estate industry experience and the founder of Wayner1031, a qualified intermediary. He can be reached at 305-281-1169 or info@wayner1031.com. |
