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1031 Classification of Second Homes

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By: Ed Horan, Certified Exchange Specialist®

To qualify for a like-kind exchange, IRC Section 1031 requires that the property be “held for productive use in a trade or business or for investment.”  The property will qualify when it is being held for use in a trade or business. Thus, the basic and most often asked question becomes:

– When is a second home being held for investment?

To examine this issue we need to categorize how second homes are used.

Rental Only:

It is clear that a property that is exclusively rented at a fair market value qualifies for a like-kind exchange.  All operating income, expenses, and depreciation are reported on Schedule E of the taxpayer’s IRS Form 1040.

Rental with Restricted Personal Use:

Personal use is within the time restrictions as set forth in IRC Section 280A.  Restricted personal use is considered as no more than 14 days or

10% of the days actually rented at a fair market rental price, whichever is greater. Such a rental would be considered as being held for business purposes under Section 1031.           Thus, it is accepted within the exchange industry that rental with restricted personal use should qualify for a like-kind exchange.

Part Personal Use and Part Rental Use:

The controversial part of this issue occurs when the personal use exceeds the limitations of IRC Section 280A, but the property is rented for part of the year. If the personal use limitations are exceeded then the property is not considered as being held for business but could qualify as an investment property. Most practitioners maintain that Section 280A does not determine if the property can qualify for a like-kind exchange. What Section 280A does is establish specific rules on what tax deductions can be taken if personal use exceeds the established limits. Basically, rental expense deductions cannot exceed gross rental income. If the taxpayer has used a second home in excess of the 14 days or 10% of days actually rented (Section 280A criteria), they need to recognize that the IRS may review the facts to determine if the taxpayer had a primary profit and investment motive.  No one can give an assurance that the property will qualify for a like-kind exchange if the annual personal use exceeds the Section 280A restrictions.

Personal Use-Rental Not in Excess of 14 Days:

IRC Section 280 permits both a principal residence and second home to be rented out for no greater than 14 days without claiming either income or expenses. There should be no question that the primary use of the property is personal use and thus it would not qualify for a like-kind exchange.

Personal Use Only:

There is no question that if a second home is used exclusively for personal use that it does not qualify for a like-kind exchange.

No Personal Use and No Rental- Second Home Held Vacant:

This situation does not occur very often.   If a second home is held vacant in anticipation of an increase in value, the property would be considered held for investment and should qualify for a like-kind exchange.

What is Personal Use?

The IRS definition of “personal use” is very broad. IRS Tax Topic 415 describes a day of personal use of a dwelling unit as any day that it is used by:
1. The taxpayer or any other person who has an interest in it (co-owner), unless the interest is rented to another owner as his or her main home under a shared equity financing agreement;
2. A member of the taxpayer’s family or a family member of any other person who has an interest in it, unless the family member uses it as his or her main home and pays a fair rental price;
3. Anyone under an agreement that lets the taxpayer use some other dwelling unit; or
4. Anyone at less than the fair market rental price. Any day in which the taxpayer does substantially full-time repairs or maintenance, even while others there enjoy themselves, will not be counted as a personal use day.

It is clear that in five of the six categories listed above, a property may or may not qualify for use in a 1031 like-kind exchange. Unfortunately, for most vacation area second homeowners, the uncertainty occurs when a property is extensively rented but personal use exceeds the Section 280A 14 days or 10% of actual rental day’s limitation.

The conflicting views and advice set forth in the two recent articles highlight the problem. The most conservative advice given was “for at least two years do not use the (rental) property at all, so that there is no doubt that is a rental property.” The more practical view given in the Wall Street Journal article is to recognize that personal use in excess of the Section 280A tax deduction restriction does not always eliminate a property from qualifying for a Section 1031 exchange. The amount of rental and personal use are important considerations. Also, investment intent, rental efforts and the profit motivation of the taxpayer may also be important factors.

Until the IRS provides more specific guidance, taxpayers should recognize that using a rental property that exceeds the Section 280A limits as a qualifying property in a 1031 exchange could, in the event of an IRS audit, lose the argument that the property was being held for investment purposes.

The more the taxpayer limits personal use and has an extensive rental history, the greater the case for predominant profit motive and demonstrated intent to hold the property for investment. If it is unclear that an exchange property will qualify, the taxpayer should always seek the advice of their CPA or tax adviser.

-Ed Horan, CES®, is Senior Exchange Consultant for Realty Exchange Corporation, Gainesville, VA, and author of How to Do a Like-Kind Exchange of Real Estate – Using a Qualified Intermediary.

 

This publication is designed to provide accurate information on tax-deferred exchanges. The publisher is not engaged in rendering legal or accounting services. If legal or tax advice is required, the services of a competent professional should be sought.

Vacation Home Revenue Procedure 2008-16

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Safe Harbor for Vacation Home

The IRS published Revenue Procedure 2008-16 for the purpose of providing a Safe Harbor under which the IRS will not challenge whether a dwelling unit with limited personal use qualifies as property held for productive use in a trade or business or for investment for purposes of Section 1031 of the Internal Revenue Code.

Dwelling Unit

For this Revenue Procedure, a dwelling unit is real property improved with a house, apartment, condominium, or similar accommodations including sleeping space, bathroom, and cooking facilities. The Revenue Procedure says, “The Service recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but that they also use the properties occasionally for personal purposes.” This Revenue Procedure applies to the exchange of dwelling units occurring on or after March 10, 2008.

Qualifying Use

The Qualifying Use Standards established in Section 4 of the Revenue Procedure are new. If the standards are met, the IRS will not challenge whether the dwelling unit is held for a qualifying use in an exchange. The Qualifying Use Standards are applied to either the relinquished property or the replacement property and are:

a) that the dwelling unit with limited personal use is owned at least 24 months before the exchange if it’s the relinquished property, or 24 months after the exchange if it’s the replacement property;

b) that, within the applicable 24-month qualifying use period, in each of the two 12-month periods, the taxpayer rents the dwelling unit to another unrelated person or persons at fair value rental for 14 days or more. A related person may rent at fair value if the dwelling is a principal residence for the related person (§§280A(d)(2) & 280A(d)(3)), and

c) that the property must be a dwelling unit.

A taxpayer utilizing the Safe Harbor in this Revenue Procedure also must satisfy all other requirements for a like-kind exchange under Section 1031 and the regulations thereunder.

Each Property

If you want to use the Safe Harbor, the Revenue Procedure looks at each property to determine if personal use is too high and if actual rental income is generated. If you have a relinquished dwelling with personal use, we now know that if you wish to use the safe harbor, you should own it 2 years before an exchange, rent it to someone other than direct family at fair value for at least 14 days in each of the 2 years, and limit personal use to 14 days or 10% of the days rented, whichever is larger.

The same logic applies if the dwelling unit is your replacement property — own the replacement 2 years after an exchange, rent it to someone other than direct family at fair value at least 14 days in each of the 2 years, and limit personal use to 14 days or 10% of the days rented, whichever is larger.

Personal Use and Holding Period

We are always asked “How much personal use is too much?” and “How long do I have to hold?” Many taxpayers dream of eventually moving into their rental property and converting it to a principal residence. Section 121 of the tax code defining the tax treatment on our homes even provides for this eventuality (§121(d)(10)).

This IRS Revenue Procedure 2008-16 provides a Safe Harbor answer when you are completing an exchange.

Fact Sheet 2008-18

In March 2008 the IRS published Fact Sheet 2008-18, entitled “Like-Kind Exchanges Under IRC Code Section 1031.” In the fact sheet the IRS explains exchange property qualifications, time limits, identification rules, importance of a Qualified Intermediary, computation of basis, and reporting the exchange. For more detailed instructions purchase the book How To Do A Like-Kind Exchange of Real Estate: Using a Qualified Intermediary by Ed Horan.

Bill Horan, a Certified Exchange Specialist®, and Ed Horan is Senior Exchange Consultant for Realty Exchange Corporation, Gainesville, VA.

This publication is designed to provide accurate information on tax-deferred exchanges. The publisher is not engaged in rendering legal or accounting services. If legal or tax advice is required, the services of a competent professional should be sought.

1031 Exchange of Vacation Property

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Our concern is that many writers are implying that a 1031 exchange can be done only if the conditions in IRS Revenue Procedure 2008-16 are met. This is not correct !! Since it was never clearly stated when second homes could qualify for a 1031 exchange, the IRS under pressure published Revenue Procedure 2008-16, effective March 10, 2008. The procedure clearly says you can do “safe harbor” exchange of dwelling units if both meet the ‘qualifying use periods’ and ‘personal use’ limits. As a “safe harbor” exchange it will not be challenged by the IRS. It was never intended to state when a 1031 exchange can be otherwise accomplished. Also, you do not have to exchange for another vacation home, just another piece of real estate whose use will qualify. Taxpayers claiming use of the ‘safe harbor’ also must satisfy all other Section 1031 requirements and regulations.

Can you still do a 1031 exchange following the 1031 law and regulations? Absolutely!!

These rules state that to qualify both the relinquished and replacement properties must be held for productive use in trade or business (like a rental) or for investment. While a specific holding period is not stated it is recommended that both properties be held at least one year. If a tax payer wishing to do an exchange has personally used a second home annually in excess of 14 days or 10% of the days actually rented they need to be aware that the IRS may review the facts to determine if the taxpayer had a qualifying use and profit motive. An explanation of the 2008-16 provisions are available at: Vacation Home Revenue Procedure 2008-16

Hurricanes and Like-Kind Exchanges

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By: Ed Horan, Certified Exchange Specialist®

It is a stretch to see the connection between hurricanes and like-kind real estate exchanges. But the IRS has found an important one.

In January of last year the IRS published Revenue Procedure 2004-13 which provided guidance in the event of a presidentially declared disaster on the treatment of the multitude of time sensitive deadlines covered by the Internal Revenue Code (IRC).

That guidance as it pertained to IRC 1031 and like-kind exchanges provided extensions for only the 45-day identification and 180-day exchange periods. Also, only individuals and businesses located in the disaster area, or whose records were located in the area, and disaster workers could qualify for the extension.

As we all know 2004 was a year full of hurricanes and other natural disasters which covered broad areas of the country. As a result the exchange relief provisions in Revenue Procedure 2004-13 were given a major test. They were found to be lacking in scope and the conditions needed to qualify.

New Rules

The IRS announced in late January 2005 (IRS Notice 2005-3, IRB 2005-5) that shortly Revenue Procedure 2004-13 will be retroactively modified to (1) add a minimum 120-day deadline extension for exchangers, (2) add for the extension of „reverse exchange‟ deadlines, and (3) add to the conditions and categories which will qualify the like-kind exchanger for deadline extensions. The new provisions are retroactive to January 26, 2004, and effective immediately.

When there is a presidentially declared disaster, the IRS issues a News Release. The News Release will list the area affected, the extension period, and the disaster designation. For example:  a News Release, dated January 26, 2005 identifies as a presidential disaster area the 62 counties in Indiana that were struck by severe winter storms and flooding. The extension period is January 1, 2005 to March 25, 2005. The disaster designation is “Winter Storms-IN.

Time Sensitive Dates

In addition to the provisions for the current extension of the 45-day identification date and the 180-day exchange period suspense dates, the four time sensitive suspense dates for a “reverse exchange‟ are now included. These dates are the 5-day period to enter into a Qualified Exchange Accommodation Agreement (QEAA), the 45-day identification period for the relinquished property, the 180-day Exchange Accommodation Titleholder (EAT) holding period, and the 180-day combined period.

Regardless of the last extension date provided in the News Release, the exchanger will have a 120-day extension from the last day of the 45-day identification period, the 180-day exchange period, and the four reverse exchange suspense dates. The new 120-day extension date or the last day of the extension period in the News Release, whichever is later, will apply.

Broader Qualification

In comparison to the previous conditions necessary to qualify for an extension, the new rules are more realistic. An affected exchanger now qualifies for a postponement:

(a) If the relinquished property was transferred (or the property transfer to the EAT in a “reverse exchange‟) on or before the date of the presidentially declared disaster, and

(b) the exchanger has difficulty meeting the exchange deadlines because the relinquished or the replacement property is located in the disaster area; the principal place of business of any party to the transaction (for example, a qualified intermediary [QI], EAT, transferee, settlement agent, lender, or title insurance company) is located in the disaster area; any party to the transaction (or an employee involved in the 1031 transaction) is killed, injured or missing as a result of the disaster; a document prepared in connection with the exchange or a relevant land record is destroyed, damaged, or lost as a result of the disaster; a lender decides not to fund the loan or refuses to fund the loan due to the lack of flood, disaster or hazard insurance; or a title insurance company cannot provide a policy due to the disaster.

Damage to Exchange Property

An additional new provision is that the 120-day extension will also apply if an already identified replacement property or an identified “reverse exchange‟ relinquished property is substantially damaged by the disaster.  This means that if, for example, a relinquished property already identified is substantially damaged, the exchanger could identify a new replacement property if within the 120-day extension period.

Coordination Important

If an exchanger is going to extend a deadline, they should immediately coordinate with their Qualified Intermediary to establish the new suspense dates. To advise the IRS that the extension has been used, a taxpayer should mark in red on the top of their IRS Form 8824 reporting the exchange the disaster designation.

While no one wants to be involved in a real estate transaction in the middle of a disaster, at least the IRS has provided the time for exchangers to solve some of the problems associated with what can be tight time-sensitive dates when doing an exchange.

-Ed Horan, CES® is Senior Exchange Consultant for Realty Exchange Corporation, Gainesville, VA, and author of How to Do a Like Kind Exchange Using a Qualified Intermediary

 

This publication is designed to provide accurate information on tax-deferred exchanges. The publisher is not engaged in rendering legal or accounting services. If legal or tax advice is required, the services of a competent professional should be sought.

Qualifying A Vacation Property for a Like-Kind Exchange

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By Ed Horan, Certified Exchange Specialist®

Vacation Property Conversions

When they talk about conversion in the real estate industry it is usually the process of converting an apartment building into condominiums. In the exchange world a conversion means changing a property from IRC 1031 qualifying status to non- qualifying status or vice versa.  The most common exchange conversion occurs when a replacement property received in an exchange and held as a rental for a year or so is converted to personal use. The personal use can be as a principal residence, a second home or a vacation home with some rental.

Conversion to Personal Use

When a property is converted to personal use, then in the judgment of most tax authorities it no longer qualifies for a 1031 like-kind exchange. If the personal use of the property is greater than 14 days or 10 percent of the days actually rented at a fair rental price, then it may become a property held for personal use. Thus, the IRS definition of personal use becomes very important. The IRS definition of personal use is very broad and could catch a taxpayer unaware. In IRS Publication 527 personal use is defined as “any day that the unit is used by any of the following persons” – you (the taxpayer) or any other person who has an interest in the property; a member of your  family  or  a  member  of  any  other  co-owner’s  family;  anyone  under  an arrangement that lets you use some other dwelling unit; or anyone at less than a fair rental price. Fortunately maintenance days do not count, even if your family uses the unit while you are repairing it. The tax consequences of converting a rental property to full personal use or partial rental are significant. For instance, rental expenses in excess of rental income may not be deducted but must be carried forward to the next year. For details see IRS Publication 527 at www.irs.gov.

In addition, the property may no longer qualify for a 1031 exchange. For a property to qualify for an exchange, IRC Section 1031(a)(1) requires the property to be “held for productive use in a trade or business or for investment.”  As explained below, when the time comes, the personal use vacation home can be converted back to a rental to qualify for a 1031 exchange.

Conversion to Investment Use

A taxpayer may have purchased a property solely for personal use as a vacation home. If it remains in personal use status when the time comes to sell the property, any gain will be fully taxed by both the state and federal governments. To defer the gain on the property by doing a 1031 exchange, the property must be converted to 1031 qualifying use. A vacation home is converted to qualifying use when personal use is limited, and it is rented or offered for rent. How long must a converted property be “held for productive use in a trade or business or for investment” to qualify for a 1031 exchange? No one can answer that question with certainty.

There is one 1984 Private Letter Ruling which says a two-year rental period is sufficient. However, most tax advisers suggest that a one-year rental period would demonstrate that the property has been held for investment or business.

Reporting Personal Use to the IRS

If you have rental income, then you report it to the IRS on Form 1040, Schedule E. This form reports for each rental real estate property the income, allowable expenses and depreciation taken. Also of importance, on line 2 of Schedule E, for each rental property listed, you must answer yes or no to “did you or your family use it for personal purposes for more than the greater of 14 days or 10% of the actual days rented at fair rental value during the tax year?” To qualify for a 1031 exchange, the Schedule E should reflect that personal use of the property was limited. If your property has been held for personal use and you now wish to convert it to business use so that you may complete a 1031 exchange, it is important that you discuss the details with your CPA or tax adviser.

-Ed Horan, CES®, is Senior Exchange Consultant for Realty Exchange Corporation, Gainesville, VA, and author of How to Do a Like Kind Exchange of Real Estate – Using a Qualified Intermediary

 

This publication is designed to provide accurate information on tax-deferred exchanges. The publisher is not engaged in rendering legal or accounting services. If legal or tax advice is required, the services of a competent professional should be sought.