On February 15, 2008, the Internal Revenue Service issued a revenue procedure, Rev. Proc. 2008-16, which provides new safe harbor rules for dwelling units under Section 1031 of the Internal Revenue Code. These rules became effective March 10, 2008.
A "dwelling unit" is defined as "real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities."
In essence, if the taxpayer is contemplating a 1031 exchange of a dwelling unit, he should qualify the transaction by conducting an analysis of the facts. The threshold question is whether the dwelling unit, in the past 24 months, has been used solely as a personal residence. The rule is that if the property has been used solely as a personal residence, it does not qualify for 1031 exchange purposes. If, on the other hand, the property has been rented at a fair rental value during each of the preceding two 12 month periods and personal use of the dwelling unit does not exceed the greater of 14 days or 10% of the number of days the property was rented at a fair rental value during each of the preceding two 12 month periods, the property could qualify under 1031.
Provided that the following rules and guidelines are followed, the IRS will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031:
Rule 1. Use of the Property
A. The dwelling unit in question must not be used solely as a personal residence; but
B. The dwelling unit may be used occasionally for personal use if the primary purpose of the property is the production of current rental income.
Rule 2. Property must be owned for the Qualifying Use Period and personal use cannot exceed the greater of 14 days or 10% of number of days property was rented at a fair rental value.
A. The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the "qualifying use period"); and
B. Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) 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 this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).
Example 1: Taxpayer has owned the dwelling for at least 24 months prior to the exchange. In each of the last two years, he rents the dwelling unit at fair rental value for at least 14 days and his personal use for each year does not exceed 14 days. This property would qualify for exchange under 1031.
Example 2. Taxpayer has owned the dwelling for at least 24 months prior to the exchange. In each of the last two 12 month periods, he rents the dwelling unit at fair rental value for 270 days and he uses the property for personal use for 27 days. This property would qualify for exchange under 1031 because the personal use did not exceed 10% of the number of days during the 12 month period the property was rented at fair rental value.
Example 3. Taxpayer has owned the dwelling for at least 24 months prior to the exchange. In each of the last two years, he rents the dwelling unit at fair rental value for 270 days and he uses the property for personal use for 30 days. This property would not qualify for exchange under 1031 because the personal use exceeded 10% of the number of days the property was rented at fair rental value.
Rule 3. If the Replacement Property is also a dwelling unit, the same qualifying rules for a relinquished property apply to the Replacement property. In other words, if Taxpayer intends to use the dwelling unit replacement property for the same purposes as the dwelling unit relinquished property, the transaction would qualify under 1031:
A. A dwelling unit that a taxpayer intends to be replacement property in a § 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,
(a) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(b) 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 this purpose, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.
The revenue procedure also defined the following:
Personal use. Personal use of a dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes.
Fair rental. Fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the parties to the rental agreement are taken into account.
Special rule for replacement property:
If a taxpayer files a federal income tax return and reports a transaction as an exchange under § 1031, based on the expectation that a dwelling unit will meet the qualifying use standards for replacement property, and subsequently determines that the dwelling unit does not meet the qualifying use standards, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange under § 1031.
Limited Application of Safe Harbor:
The safe harbor provided in this revenue procedure applies only to the determination of whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under § 1031. A taxpayer utilizing the safe harbor in this revenue procedure also must satisfy all other requirements for a like-kind exchange under § 1031 and the regulations thereunder.
In summary, if the taxpayer owns a "vacation home" or "second home" that he only occasioally uses for personal purposes, and keeps it rented at a fair rental value, he could qualify the property for a tax deferred 1031 exchange. Competent tax advice should be obtained, and the usual caveats and disclaimers apply.
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