Most tax practitioners serve
clients who own vacation-second homes. These dwellings take on many personas -- a beautiful home in the
country, a cozy cottage on the lake, a gorgeous condominium on the ocean, or a rustic
cabin in the mountains.
The exclusion of gain under IRC
Section 121 does not apply to second homes because the principal residence requirements
are not met. As a result, this does not
leave clients with many options for deferral of taxes when they dispose of
their vacation-second home asset.
However, there is one major
tax strategy that comes to the rescue: Section
1031 Tax Deferred Exchange.
The cloudy area for tax
practitioners was how to ensure that vacation-second homes qualified under
Section 1031. Recently, the IRS created
a new formula -- Rev. Proc. 2008-16. Following this formula, the dwelling unit will qualify as a “like kind
property” under Section 1031. The new IRS
procedure1 assures that the IRS (“the Service”) will not challenge
whether a dwelling unit qualifies as property held for productive use in a
trade or business or for investment in order to be eligible for safe harbor
protection under Internal Revenue Code (“IRC”) Section 1031.
In a recent
conversation with J. Peter Baumgarten of the Office of Associate Chief Counsel
(Income Tax & Accounting) of the Service and the author of Rev. Proc.
2008-16, we discussed many of the issues presented herein. We agreed that, as a result of the Rev.
Proc., tax practitioners now have a standard that is easily identifiable for
determining whether a client’s dwelling unit (vacation home/second home) should
qualify as an investment or property held for productive use in a trade or
business under Section 1031.
For background purposes, IRC
Section 1031 is known as the “Tax Deferred Exchange” provision. It indicates that no gain or loss is
recognized on the Exchange of property held for productive use in a trade or
business or for investment (relinquished property) 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 (replacement property).2
_________________________________________________________________________________________________________
1 Rev.
Proc. 2008-16
2 IRC
Section 1031(a)
As far back as 1959, the
Service concluded that gain or loss from an Exchange of personal residences may
not be deferred under Section 1031 because personal residences are not property
held for productive use in a trade or business or for investment.3
In Moore
v. Commissioner4, the
taxpayers sold one home on a lake and tried to Exchange that for another home
on the same lake. Neither of these homes
were ever rented nor ever offered for rent. Expenses were never deducted under Section 212 for business or
investment expenses. Instead, interest
was deducted under Section 163 as personal home mortgage interest rather than
as investment interest and both homes were used exclusively by the taxpayers
for their own personal use. The
taxpayers stated that because they expected the homes to appreciate in value,
the homes should then qualify under Section 1031 for a tax deferred Exchange. The Tax Court disagreed and held that
properties with 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.”5
So, if the taxpayers could
not qualify for Section 1031 tax deferral treatment because they were the only
users of the property, the next issue for consideration was whether vacation
homes minimally used by taxpayers could qualify under Section 1031 for tax
deferral treatment. Moreover, what if
the vacation/second home property was only rented out for a short period of
time each year? Could that property
meet the criteria of an investment and thereby qualify for Section 1031 tax
deferral treatment?
Historically, Section 280A covered
the issues of allowing deductions on dwelling units that taxpayers use as
residences, which included vacation and second homes. This section states that a taxpayer who personally
uses the dwelling unit the greater of 14 days a year or 10% of the number of
days during the year for which the dwelling unit is rented at fair market
value, is using the property as a “residence” and not as an “investment”.6 “Personal use” under this section of
the IRC not only includes use by the taxpayer but also includes any member of
the taxpayer’s family, or anyone who is a co-owner; or use by any person utilizing
the dwelling unit under an agreement which enables the taxpayer to use some
other dwelling unit (whether or not a rental is charged for the use of such
other unit); or if in fact an individual rents the unit for less than fair
market value.7
_________________________________________________________________________________________________________
3 Rev.
Rul. 59-229, 1959-2 C.B. 180
4 Moore
v. Commissioner, T.C.Memo. 2007-134
5 Id.
6 IRC
Section 280A(d)
7 Tax Free
Exchanges Under Section 1031(2007),
Long and Foster, Thomson/West,
Page 2-37.
Most would agree with one tax
analyst’s statement on Section 1031, who suggested it would be unwise for a
taxpayer to deduct mortgage interest on a vacation home as a second home and
then take the position that the property was held for investment under Section
1031. Knowing that many taxpayers hold
dwelling units primarily for production of rental income, but at the same time
occasionally use the property for their own personal use, the Service recently
produced Rev. Proc. 2008-16 to clarify some of these issues.
Under Rev. Proc. 2008-16, the
Service will not challenge whether a dwelling unit (“is real property improved
with a house, apartment, condominium, or similar improvement that provides
basic living accommodations including sleeping space, bathroom and cooking
facilities”8) qualifies under section 1031 as property held for
investment or held for productive use in a trade or business, if the qualifying
use meets the following standards:
(1) For the
Relinquished Property:
(a) the dwelling
unit must be owned by the taxpayer for at least 24 months immediately before
the Exchange defined as the “qualifying use period”9 and
(b) Within the
qualifying use period, in each of the two 12 month periods immediately
preceding the Exchange:
(i) The taxpayer
must rent, at fair rent, for at least 14 days or more the dwelling unit to
another person or persons, and
(ii) The taxpayer may
not personally use the dwelling unit the greater of 14 days or 10 percent of the
number of days during the 12-month period that the dwelling unit was rented to
another at a fair rental rate.10
The Service has provided a similar
set of rules for the Replacement Property.
(2) For the Replacement Property:
(c) The dwelling
unit must be owned by the taxpayer for 24 months or more immediately after the Exchange
(the “qualifying use period”); and
(d) Within the
qualifying use period, in each of the two 12-month periods immediately after
the Exchange:
______________________________________________________________________
8 Rev.
Proc. 2008-16, Section 3.02
9 Rev.
Proc. 2008-16, Section 4.02 (1)(a)
10 Rev.
Proc. 2008-16, Section 4.02 (1)(b)
(i) The taxpayer must
rent, at fair rent, to another person or persons for at least 14 days or more,
and
(ii) The taxpayer may
not personally use the dwelling unit the greater of 14 days or 10 percent of the
number of days during the 12-month period that the dwelling unit was rented to
another at a fair rental rate.11
The Service defines
“personal use of a dwelling unit” as occurring on any day that the taxpayer is
deemed to have used the dwelling unit for personal purposes under Section
280A(d)(2), taking into account Section 280A(d)(3), but not Section 280A(d)(4)12.
What is a “fair
rental”? Normally a real estate
practitioner would describe that term as fair market rent, but the Service uses
the term “fair rental” and determines it to be based upon all of the “facts and
circumstances” that exist when the rental agreement was entered into between
the parties. The Service will also look
at all of the rights and obligations of the parties to the rental agreement.13
What happens if the taxpayer
files its federal income tax return and reports the transaction as a Section
1031 Exchange, believing that the dwelling unit used as a replacement property
will meet the appropriate qualifying standards, and then it is determined that
this replacement property does not meet the necessary qualifying
standards? The Service suggests that the
taxpayer file an amended return and not report the transaction as an Exchange
under Section 1031.14
Rev. Proc. 2008-16 is
limited in that it only determines whether a dwelling unit qualifies as property
held for productive use in a trade or business or for investment under Section
1031.15 It does not give
safe harbor protection for all of the other requirements for a “like kind”
Exchange under Section 1031 or under the Section 1031 Regulations.16 The effective date of Rev. Proc. 2008-16
is March 10, 2006.17
What happens if the
taxpayer’s dwelling unit does not qualify under Rev. Proc. 2008-16 for safe
harbor protection? The taxpayer may
still try to qualify for Section 1031 treatment, but it will have to overcome
the requirements set forth in Rev. Proc 2008-16. ______________________________________________________________________
11 Rev.
Proc. 2008-16, Section 4.02 (2)(b)
12 Rev.
Proc. 2008-16, Section 4.03
13 Rev.
Proc. 2008-16, Section 4.04
14 Rev.
Proc. 2008-16, Section 4.05
15 Rev.
Proc. 2008-16, Section 4
16 Id.
17 Rev.
Proc. 2008-16, Section 5
Following are examples that
illustrate how this new Rev. Proc. works. In the first example, Taxpayer Tessie has a “second home” that she has
rented out for the past five years to the same renter for the entire
summer. Tessie uses the property for 10
days a year during Thanksgiving and Christmas vacations. Tessie reports the income from the rental on
her income tax return and now wants to sell the property and use Section 1031
to purchase a small shopping center in her home town. Tessie’s “dwelling unit”(second home) will
qualify for tax deferral treatment under Section 1031 because she rented the
dwelling unit for more than 14 days a year, 18 she never personally used the dwelling unit for more
than 14 days in any one year19, and finally she exchanged the
dwelling unit for real estate that qualifies as “like kind”20
property.
In the second example, Taxpayer
Tim is a different story. Tim has owned
a mountain cabin on a lake for 20 years. Every year, Tim spent the summer fishing on the property. About five years ago he rented, at below fair
rent, the dwelling unit to a fishing buddy of his for one week. He never reported the income and never tried
to rent the dwelling to anyone else during the entire 20 year period he owned
the cabin. Tim is now selling the cabin (dwelling
unit) and wants to buy another cabin, higher on up the mountain.
According to Rev. Proc
2008-16, Tim’s mountain cabin will not qualify as a dwelling unit (relinquished
property) for Section 1031 purposes, because he did not have it rented at a
fair rental for at least 14 days in each of the preceding 2 years prior to the
transfer21; and he used it for more than 14 days a year or 10 per
cent of the number of days that he had the dwelling unit rented22. Another important problem is that Tim did not
rent the unit to his friend at fair market.23 The property Tim wants to purchase will
probably not qualify as “like kind” because there is no intent to use it as an
investment property or property used in a trade or business.24
Rev. Proc. 2008-16 would
seem to clear the air on many of the foggy issues surrounding 1031 Exchanges
for vacation and second homes. That
said, the taxpayer must still satisfy any and all of the other requirements for
a like-kind Exchange in order to qualify for tax deferred treatment.25
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18 Rev.
Proc. 2008-16 Section 4.02(1)(a)
19 Rev.
Proc. 2008-16 Section 4.02(1)(b)
20 1031(a)
21 Rev.
Proc. 2008-16 Section 4.02(1)(b)(i)
22 Rev.
Proc. 2008-16 Section 4.02(1)(b)(ii)
23 Rev.
Proc. 2008-16 Section 4.04
24 Section
1031(a)
25 Rev.Proc.
2008-16, Section 4.06
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