IRS provides safe harbor guidance for personal use of Section 1031 investment home

Recognizing that many taxpayers who own properties primarily for rental income use them occasionally for personal purposes, the Internal Revenue Service (IRS) in February clarified safe harbor rules for personal use of properties that are held under IRC Section 1031 as for productive use or for investment. These properties qualify for deferred payment of capital gain.

The personal use standards will apply for Section 1031 exchanges after March 10, 2008, but in the current real estate market, and with changes in capital gains rates on the horizon under a new administration, the Section 1031 strategy may not be as popular as it has been.

The IRS had not previously published guidance for limited personal use. But in July 2007, the Tax Court upheld the IRS in Moore v. Commissioner, where taxpayers claimed that they were qualified for a Section 1031 exchange when they exchanged one lake front vacation home for another, because the properties were considered investments that were expected to increase in value. The Court held 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."

Although the IRS challenge was upheld because neither home was ever rented, and the properties were held exclusively for personal use, the IRS, prodded by a report by the Treasury Department inspector general, decided that it would issue guidance on personal use, the Washington Post reports.

Under the safe harbor personal use rules for the relinquished property, the property qualifies for a Section 1031 exchange if:

a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before 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,
i. The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
ii. The period of the taxpayer's personal use of the dwelling unit does not 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 rental.

The same rules apply for the Replacement property except that the dwelling unit must be owned by the taxpayer for at least 24 months immediately after the exchange.

Some investors in real estate, anticipating a change in capital-gains rate with a new administration, are turning away from the Section 1031 exchange strategy and choosing to pay the capital gain on the sale of their properties at current rates, The Wall Street Journal reports.

Others are having difficulty finding good investment properties that qualify as like-kind for Section 1031 purposes, especially in the commercial market. In an interview with the Journal last summer, Marsha Slotten, a commercial real-estate broker in Las Vegas, said that investors looking for commercial properties to exchange are essentially "wasting their time. . . . Most of the properties that are still available are significantly overpriced."

The Washington Post reports that the IRS has indicated it intends to increase audits and enforcement of Section 1031 exchanges starting this summer.

The IRS discussion of the background for safe harbor for like-kind exchanges, the scope and application are published as Rev. Proc. 2008-16.

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