By
Stephen A. Wayner, Esq., CES, Bayview
Financial
With
the recent gains in the real estate market, the approaching retirement age and
increased mobility of the "baby boomer" generation, and the record
wealth transfer now in full flower, professionals are seeing a growth in
pent-up demand for Code Section 1031 Tax Deferred Exchanges. Taxpayers are
frequently asking their professional advisors whether they can qualify their
vacation homes, or primary and secondary residences for a Code Section 1031
exchange.
Exchange Mechanics. There are two properties that are considered in the
typical exchange: the property being sold (the "relinquished
property"), and the property being purchased (the "replacement
property").
Vacation Homes. Vacation homes, primary and
secondary residences (hereinafter referred to collectively as "Personal
Use Realty") generally have not qualified for Section 1031 tax deferral,
if either the relinquished property or the replacement property is Personal Use
Realty, since they are not considered to be “held” for investment or business
purposes. If either: (1) the relinquished property was previously used as
Personal Use Realty; or (2) the replacement property is intended to ultimately
be used as Personal Use Realty; in order to conduct a valid §1031 exchange it
is often necessary to have such property rented to unrelated parties for a
period of time both before and after the exchange.
How Can I Make Sure my Property Qualifies? Section 1031 contains no
fixed amount of time needed to qualify a transaction for tax-deferred status.
Instead, Section 1031 requires that the taxpayer have the intent to hold the
property for either an investment purpose or a business purpose, at the time of
the exchange to avoid a taxable exchange. The case law on Section 1031 follows
a line of precedence where courts will attempt to determine the taxpayer's
intent...
he court applies a "facts and
circumstances" test to objectively measure whether the taxpayer had a bona
fide intention to hold each property as investment or business property at the
time of the exchange. The taxpayer's actions, written and oral communications,
and tax filings, constitute evidence for examination if the Internal Revenue
Service challenges the tax-deferred status of the exchange. The following chart
illustrates some of the factors that the Internal Revenue Service will likely
examine:
|
EVIDENCE AGAINST
INVESTMENT OR BUSINESS INTENT |
EVIDENCE FOR
INVESTMENT OR BUSINESS INTENT |
|
The taxpayer puts up a "for sale" sign, lists the
property for sale, or signs a listing agreement soon after its purchase. |
The taxpayer sells the property on his own, receives an
unsolicited offer, or lists the property for sale after holding as an
investment for a substantial length of time. |
|
The taxpayer applies for "owner occupied" financing
on the property. |
The taxpayer obtains financing listing himself as a
non-occupant investor. |
|
The taxpayer inadvertently checks a box in the Purchase and
Sale Contract that he intends to live in the property. |
The taxpayer is careful to read the entire Purchase and Sale
Contract to avoid any reference to his occupying the property. |
|
The taxpayer moves into the replacement property soon after
its purchase. |
The taxpayer waits for at least two (2) tax filing periods
before moving into the property. |
|
The property is not rented during the term that the property
has been held, or the leases have been in effect for a brief period. |
The property has been rented by its tenants for a significant
time. |
|
The taxpayer claims the "mortgage interest"
deduction for the property on his tax return. |
The taxpayer treats the property on his books and income tax
returns as investment or business use property |
|
The taxpayer "swaps" rental time in the replacement
property for rental time in another party's property. |
The taxpayer does not exchange rental time or act in a manner
similar to a "time-share" arrangement. |
Changes in Purpose. The purpose for holding the
property must be for investment or business use in order to qualify for Section
1031 treatment; nevertheless, the purpose may change during the holding period.
In Internal Revenue Service Revenue Ruling 57-244, property that the taxpayer
originally owned as his primary residence and was later converted into rental
property, qualified as investment property. The determination of the taxpayer's
intent is made at the time of the exchange, not at the time of the property's
acquisition.
How Much Personal Use is Permitted? Mere
incidental personal use of property that is otherwise considered investment
property may not disqualify the property from 1031 Exchange treatment, according
to Internal Revenue Service Private Letter Ruling 8103117 (remember that these
rulings are only binding with respect to the taxpayer who requested the ruling,
though they are some evidence of the IRS's position) . "Incidental
personal use" is not defined by the Code, Regulations, or by other
guidance issued by the IRS. If the property is not rented out by the taxpayer,
then use of the vacation home for anything other than "incidental personal
use" will disqualify the property from receiving tax-deferred exchange
treatment.
For exchange purposes, subsection (d) of Section 280A contains the primary test
likely to be applied. Personal use of the property does not exceed the greater
of:
1. fourteen (14) days; or
2. ten percent (10%) of the number of days that the
property is rented at fair market value to others.
Is there a Minimum Holding Period? Some commentators have believed that
the taxpayer should hold each exchange property for at least two (2) years. In
Rev. Rul. 84-121, the Internal Revenue Service
asserted its position that relinquished property acquired and exchanged soon
after its acquisition will not qualify for a Section 1031 exchange, because the
taxpayer is deemed to have acquired the property with the intent to dispose of
it, rather than to hold it for investment or business purposes. Some of the
courts, especially those in the Western States have construed Section 1031 much
more liberally. In Bolker v. Commissioner, 760 F.2d
1039 (9TH Cir. 1985), the court permitted a holding period of only three (3)
months to qualify for a 1031 exchange. The court opined that the taxpayer
satisfied the holding and intention requirements by owning the property without
the intent to liquidate the investment or to use it for personal pursuits.
However, this case is the exception rather than the majority rule.
