Here is a great article by Stephen Wayner of Bayview Financial Exchange Services. Stephen is the QI expert on my "Interview with the Pros" resource and knows his stuff!
I often get asked if vacation and second homes qualify for a 1031 exchange. Here's what Stephen has to say:
How Can I Qualify my Vacation or Second Home for a 1031 Exchange?
By Stephen A. Wayner, Esq., CES, SVP Bayview Financial Exchange Services
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. The 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
The taxpayer puts up a "for sale" sign, lists the property for sale, or
signs a listing agreement soon after its purchase.
The taxpayer applies for "owner occupied" financing on the property.
The taxpayer inadvertently checks a box in the Purchase and Sale Contract
that he intends to live in the property.
The taxpayer moves into the replacement property soon after its purchase.
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 taxpayer claims the "mortgage interest" deduction for the property on
his tax return.
The taxpayer "swaps" rental time in the replacement property for rental
time in another party's property.
EVIDENCE FOR INVESTMENT OR BUSINESS INTENT
The taxpayer sells the property on his own, receives an unsolicited offer,
or lists the property for sale after holding as investment for a
substantial length of time.
The taxpayer obtains financing listing himself as a non-occupant investor.
The taxpayer is careful to read the entire Purchase and Sale Contract to
avoid any reference to his occupying the property.
The taxpayer waits for at least two (2) tax filing periods before moving
into the property.
The property has been rented by its tenants for a significant time.
The taxpayer treats the property on his books and income tax returns as
investment or business use 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.
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As always, each situation must be reviewed in its entirety to determine what options are available.
Warmly,
Paula Straub
SaveGainsTax
760-917-0858
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