1031 Tax Deferred Exchange

VACATION HOME MAY BE EXCHANGED

NEW SAFE HARBOR BY IRS

          The IRS has issued a new Revenue Procedure establishing a safe harbor under which it will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of Section 1031.  Rev. Proc. 2008-16 is applicable to any dwelling unit which has been occupied by the taxpayer before the exchange or is occupied by the taxpayer following the exchange.  The three most common scenarios to which it would apply are:

(1)    a vacation rental home used by the taxpayer before or after the exchange;

(2)    a residence from which the taxpayer has moved and has rented prior to the exchange; and

(3)    a rental property into which the taxpayer has exchanged and occupied on a part-time basis for the taxpayer's personal use or subsequently has determined to convert to the taxpayer's residence.  The IRS has adopted a very conservative approach, which is based on the rules related to deductibility of expenses related to vacation homes which are occupied part-time by the taxpayer/owner.

          Under Rev. Proc. 2008-16, a dwelling unit that a taxpayer intends to be relinquished property in a Section 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:

(1) the dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the "qualifying use period"); and

(2) within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange, the taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and the period of the taxpayer's personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental. 

          The same rule applies to replacement property. A dwelling unit that a taxpayer intends to be replacement property in a Section 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:

(1) the dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the "qualifying use period"); and

(2) within the qualifying use period, in each of the two 12-month periods immediately after the exchange, the taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and the period of the taxpayer's personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

          For example, if the taxpayer owned a vacation rental property which was rented at a fair rental for eight months (240 days) during each of the two years prior to or following the exchange, then the property would be within the safe harbor if the taxpayer used that property for personal use 24 days or fewer during each of those two years.  At the other extreme, the taxpayer could occupy the property for two weeks during each of the two years before or after the exchange, rent the property to a third party at a fair rental for two weeks during each of those two years, and leave the property vacant for the remainder of the time.

          The IRS is also applying a broad definition of personal use.  The taxpayer is deemed to have used a dwelling unit for personal purposes if used by:

(A) the taxpayer or any other person who has an interest in such unit (including a tenant in common), or by any member of the family of the taxpayer or such other person;

(B)  by any individual who uses the unit under an arrangement which enables the taxpayer to use some other dwelling unit (whether or not a rental is charged for the use of such other unit); or

(C) by any individual if rented  for less than a fair market value rental.   A taxpayer may rent the dwelling unit to a family member if the family member uses it as a principal residence (and not a vacation home) and the family member pays fair market rent.  Some taxpayer usage may be allowed for repairs and annual maintenance, to the same extent that the IRS allows such use by its regulations with regard deduction of expenses related to rental properties.

          Rev. Proc. 2008-16 is consistent with the conservative approach to the exchange of secondary or vacation residences which we discussed in our newsletter of March, 2006.  It is also consistent with the case of Moore v. Commissioner, which was discussed in our December, 2007 newsletter.  Rev. Proc. 2008-16 is effective for exchanges of dwelling units occurring on or after March 10, 2008.

          A "safe harbor" means that the IRS will not challenge the qualification of the property for exchange purposes if these tests are met.  Thus, it provides a bright line test for taxpayer to know for certain that a dwelling unit will qualify.  Failure to meet these tests does not necessarily mean that the dwelling unit does not qualify for exchange.  The ultimate test is clearly the statutory language of whether the property is held “for productive use in a trade or business " or " for investment".  There certainly will be a number of instances where property which does not meet the requirements of the Revenue Procedure will nevertheless meet the statutory test for qualification as exchange property.  However, Rev. Proc. 2008-16 is a clear indication that the IRS will be relatively conservative in making its determination as to whether or not property qualifies.  If you are contemplating an exchange out of or into dwelling unit(s) in a transaction which does not meet the tests of Rev. Proc. 2008-16, you should consult carefully with your tax professional regarding the particular facts and circumstances which support the qualification of that property for exchange purposes.