A taxpayer must satisfy a number of requirements in order to benefit from the non-recognition of capital gain provided for in Section 1031 of the Internal Revenue Code (the "IRC"). One significant (and until recently, perplexing) requirement contained in Section 1031 is that the exchanged properties be held "either for productive use in a trade or business or for investment."
Section 1031(a) states that "[n]o gain or loss shall be recognized on the exchange of property of like kind which is to be held either for productive use in a trade or business or for investment." As this language indicates, and courts have confirmed, the benefit provided by Section 1031 does not apply to exchanges in which at least one of the properties involved is a personal residence. In Starker v. United States, 602 F.2d 1341, 1350 (9th Cir. 1979), the U.S. Court of Appeals for the Ninth Circuit held that a personal residence was not eligible for exchange under IRC §1031, explaining that "[i]t has long been the rule that the use of property solely as a personal residence is antithetical to it being held for investment."
The implications of IRC §1031 become increasingly complex when a taxpayer owns a residence for reasons other than personal use. In these cases, an attempt must be made to measure the taxpayer's intent to use real property for investment. Until recently, the law has provided little guidance in relation these situations. In 2007, however, the Tax Court's decision in Moore v. Comm'r, T.C. Memo. 2007-134 examined whether certain types of vacation homes can properly be classified as investment property for purposes of IRC §1031. In Moore, the taxpayers attempted to exchange one lakeside vacation home for another, but both of the exchange properties were used by the taxpayers solely for personal purposes. Neither the relinquished property nor the replacement property was ever rented to third parties for any amount of time. The taxpayers argued that the exchange of the vacation homes should be eligible for non-recognition of capital gain as a like-kind exchange under IRC §1031 because the taxpayers expected the properties to appreciate in value, thus classifying them as being held for investment. The Tax Court, however, held that the properties were held solely 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." Id. Thus, the holding in Moore illustrates that if a taxpayer never rents a property, that taxpayer lacks the requisite intent for the property to be considered "held for investment," even if the taxpayer anticipates that the property will appreciate in value.
The Internal Revenue Service further clarified the subject of residential property for investment purposes by issuing Revenue Procedure 2008-16, which became effective for exchanges occurring on or after March 10, 2008. Recognizing that many taxpayers own homes primarily for the production of rental income, but also for occasional personal use, Revenue Procedure 2008-16 provides taxpayers in certain situations with a safe harbor under which a "dwelling unit" will qualify as property held for investment under IRC §1031, despite the fact that the taxpayer uses the dwelling unit for personal purposes from time to time. "Dwelling unit" is defined by Revenue Procedure 2008-16 as "real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities." Revenue Procedure 2008-16 states that the IRS will not challenge whether a dwelling unit qualifies as a Section 1031 exchange property held for productive use in a trade or business or for investment if: (a) the relinquished property is owned by the taxpayer for at least 24 months immediately before the exchange and a replacement property is owned for at least 24 months immediately after 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 and each of the two 12-month periods immediately after the exchange, (i) the taxpayer must rent the dwelling unit to another person or persons at fair rental value for 14 days or more, and (ii) the period of the taxpayer's personal use of the dwelling unit may not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
Under Revenue Procedure 2008-16, personal use of a dwelling unit occurs on any day in which "the taxpayer is deemed to have used the dwelling unit for personal purposes under IRC §280A(d)(2) (taking into account §280A(d)(3) but not §280A(d)(4))." In other words, personal use includes (1) use by the taxpayer or any other person who has an interest in the property, or by a family member of the taxpayer or such other person; (2) use by any individual who uses the dwelling unit under an arrangement which enables the taxpayer to use some other dwelling unit (regardless of whether rent is charged for the use of such other unit); or (3) use by any other individual if rented for less than fair market value. A taxpayer will not be treated as using a dwelling unit for personal purposes if the taxpayer rents the property to a family member and the family member uses the property as a primary residence and pays fair market rent. Whether a dwelling unit is rented at a fair rental is determined based on all the facts and circumstances that exist when the rental agreement is entered into, and all rights and obligations of the parties to the rental agreement are taken into account.
Revenue Procedure 2008-16 provides a safe harbor for purposes of determining whether a dwelling unit qualifies as a property held for productive use in a trade or business or for investment under IRC §1031. It is important to note that a taxpayer utilizing this safe harbor must also satisfy all other requirements for a like-kind exchange under Section 1031. Further, even though a property does not satisfy the terms of the safe harbor, the property may nevertheless qualify as relinquished or replacement property. Whether an exchange outside of the safe harbor of Revenue Procedure 2008-16 will qualify for non-recognition of gain under IRC §1031 is a fact specific determination, and depends on both the amount of personal use and the amount of rental time the taxpayer can demonstrate in relation to the property.
NOTE: This article is intended to provide general information only. It is not intended to be an all-inclusive review of the provisions of IRC §1031 and does not constitute legal advice. Prior to entering into a Section 1031 Tax-Deferred Exchange transaction, accounting and legal professionals should be consulted. For additional information on this or other business and real estate issues in Virginia, please contact John W. Anderson (804) 697-2020.