The Internal Revenue Service has handed investors and second-home owners a new gift in the form of a safety net that provides a "safe harbor" for taxpayers who wish to swap the property via a Section 1031 tax-free exchange even though they have enjoyed personal use of the property.
Revenue Procedure 2008-16, which goes into effect March 10, 2008, officially allows limited personal use of an investment property and will not prevent a dwelling unit from qualifying as property held for trade or business or investment use for purposes of the tax-free-exchange rules.
Many "second homes" are actually investment properties because their owners rent them out a majority of the year. The IRS has steered clear of any personal-use language regarding a tax-free exchange, but a new court case sparked a need for clarity "in the interest of sound tax administration."
In Moore v. Commissioner, the taxpayers exchanged one lakeside vacation home for another. Neither home was ever rented. Both were used by the taxpayers only for personal purposes. The taxpayers claimed that the exchange of the homes was a like-kind exchange under Section 1031 because the properties were expected to appreciate in value and thus were held for investment.
The tax court held, however, that the properties were held for personal use and that the "mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence."
"While the IRS is fully aware that many people use their investment properties for their own vacations, the agency is now saying it will not challenge a 1031 exchange just because there was personal use of an investment property," according to Rob Keasal, real estate tax specialist in the accounting firm of Anderson ZurMuehlen. "It’s the personal-use language that is new."
According to Section 1031 of the tax code, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment.
Personal residences can’t be exchanged tax-free under Section 1031 because they aren’t held for productive use in a trade or business or for investment.
In light of the Moore case, the IRS has taken a more lenient approach to exchanges. It provides taxpayers with a safe harbor (and an indirect checklist) under which a dwelling unit (real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities) will qualify as property held for productive use in a trade or business or for investment for Section 1031 purposes even though they occasionally use the dwelling unit for personal purposes. The IRS won’t challenge whether a dwelling unit qualifies under Section 1031 as property held for productive use in a trade or business or for investment as long as other exchange rules are met.
Strict personal-use rules of the investment property as a "second home" still apply. The period of the taxpayer’s personal use of the dwelling unit cannot 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 market value.
The Moore case flunked the Section 1031 tax-free exchange test for a variety of reasons, according to the tax court. The taxpayers never rented or attempted to rent the properties. And, they did not offer the replacement property for sale until they were forced to do so by the need for liquidity in connection with the division assets incident for their divorce. In addition, they failed to claim any tax deductions for maintenance expenses or depreciation connected with the properties and claimed interest deductions on both properties as home mortgage interest rather than as investment interest.
"Although the taxpayers hoped that both properties would appreciate, the tax court found in Moore that the taxpayers’ primary purpose in acquiring and holding the properties was to provide personal vacation retreats for their family," Keasal said. "You will not pass the exchange test by banking on appreciation alone. While the new guideline does provide for personal use, the IRS is clear that property has to qualify as an investment to be a candidate for a tax-free exchange."
Don’t be afraid to use your lake place or ski condo even though it’s an investment property and you plan to exchange it for another investment property down the road. If you limit your personal use, you will be sailing into the IRS’s new safe harbor.
To get even more valuable advice from Tom, visit his Second Home Center.
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