Internal Revenue Code §1031 allows the owner of real property to exchange property with a built-in gain for other real property without having to recognize the gains on the transaction. The owner will take a transferred basis in the replacement property, assuming all the requirements of §1031 are met (there are many, so it is critical to work with a tax professional in connection with any contemplated transaction). The replacement property and the divested property must be of “like kind” in order for §1031 to apply.
The question dealt with in this article is whether proceeds from the sale of residential rental properties would qualify for like-kind exchanges under §1031, if the proceeds are used to purchase a personal-use lake home (assuming all procedural rules of §1031 are followed).
SHORT ANSWER: IT DOESN’T WORK, BUT…
The short answer is no, the exchange does not qualify, but there are some creative planning options. The reason the exchange does not work is that both the property being exchanged and the replacement property must be used solely in a trade or business or for investment in order to qualify.
However, note two planning considerations:
- If property is operated as an investment property for at least twenty-four months after the exchange, a later conversion to personal use is permissible
- During such twenty-four month period, limited personal use is permissible, so long as:
- The property is rented to another person or persons at a fair rental price for 14 days or more during such period, and
- The taxpayer’s personal use does not exceed the greater of (i) 14 days, or (ii) 10% of the number of days the property is rented during the 12-month period.
In other words, so long as the lake home is rented out for at least 14 days during the 12-month period, the taxpayer can use the property for personal use for up to 14 days during such period. If the property is rented for a substantial number of days (e.g., 200 days), the taxpayer may be allowed more personal use days because 10% of 200 exceeds 14. Following the expiration of the twenty-four-month period, the personal use restrictions no longer apply.
FOR THE NERDS: MORE IN-DEPTH ANALYSIS
§1031 provides that no gain or loss is recognized on the exchange of property held for productive use in trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. Since a personal-use lake home is not held as an investment or for use in a trade or business, it does not qualify as “like kind property.”
One might argue that a lake home may appreciate in value, and is therefore held for investment. However, the Tax Court has shot down this argument, indicating that a 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 primary residence. See Moore v. Comm., T.C. Memo 2007-134; see also Starker v. United States, 602 F.2d 1341, 1350 (9th Cir. 1979).
Two lines of question seem to arise at this point. First, what if the cabin is held for investment and rental for a time, and then later converted to personal use? Second, what if the cabin is used partly for personal use and partly for business/investment?
The IRS issued Revenue Procedure 2008-16 to answer these specific questions. In general, the lake home must be used for business or investment for at least twenty-four months following the exchange in order to qualify under §1031. However, a certain number of personal use days during such period are permitted, as set forth in the Short Answer above. See Rev. Proc. 2008-16.
DISCLAIMER: THIS IS INTENDED FOR EDUCATIONAL PURPOSES ONLY AND CANNOT BE RELIED UPON IN TAKING ANY ACTION. YOU SHOULD CONSULT YOUR ATTORNEY AND TAX ADVISOR TO DISCUSS YOUR SPECIFIC SITUATION. THE SPECIFIC FACTS OF YOUR SITUATION MUST BE FULLY ANALYZED AND CONSIDERED BEFORE TAKING ANY ACTION.