Tax Law and Business Organization Strategy

IRS Gives Guidance On Personal That Won't Prevent Code Sec. 1031 Tax-Free Exchange Of Residence

The IRS has issued Revenue Procedure 2008-16 (2008-10 IRB). The Revenue Procedure provides guidelines for limited personal uses that won't prevent a dwelling unit from qualifying as property held for trade or business or investment use under the Section 1031 like-kind exchange rules.

The IRS says it recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. “In the interest of sound tax administration,'' the IRS has provided taxpayers with a safe harbor 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 Code Sec. 1031 purposes even though they occasionally use the dwelling unit for personal purposes.

The IRS won't challenge whether a dwelling unit qualifies under Code Sec. 1031 as property held for productive use in a trade or business or for investment if:

  • the taxpayer owns both properties for the qualifying use period (for the relinquished property, at least 24 months immediately before the exchange; for the replacement property, at least 24 months immediately after the exchange); and
  • within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange:
    • the taxpayer rents the dwelling unit to another person(s) at a fair rental for 14 days or more, and
    • the period of the taxpayer's personal use of the dwelling unit doesn't 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.

For the relinquished property, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months before that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months before that day). For the replacement property, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.

Personal use occurs on any day on which a taxpayer uses the unit for personal purposes by:

  • the taxpayer or any other person who has an interest in the dwelling unit or by a member of the family of the taxpayer or the other person;
  • any individual who uses the unit under a reciprocal use arrangement (other than use by a person having an equity interest in the property under a shared equity financing agreement); or
  • any individual unless for that day the dwelling unit is rented for a fair rental.

A taxpayer is not treated as using a dwelling unit for personal reasons if the unit is rented out or held for rental at a fair rental to any person for use as a personal residence. And, personal use days don't include days the taxpayer used a dwelling unit as his principal residence:

  • before or after a rental (or attempted rental) period of 12 or more consecutive months beginning or ending in the tax year, or
  • before a consecutive rental (or attempted rental) period of less than 12 months beginning in the tax year, at the end of which the residence is sold or exchanged.

The IRS stressed that the new safe harbor applies only to the determination of whether a dwelling unit is held for productive use in a trade or business or for investment under Code Sec. 1031, and that a taxpayer using the safe harbor also must satisfy all other requirements for a like-kind exchange under Code Sec. 1031 and the like-kind exchange regs.

A taxpayer may file a federal income tax return and report a swap of dwelling units as a tax-free exchange, based on meeting the qualifying use standard for the relinquished property and the expectation that he will meet the qualifying use standard for the replacement property, but ultimately he may fail to meet the latter standard. In this situation, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange under Code Sec. 1031.

Rev. Proc. 2008-16 is effective for exchanges of dwelling units occurring after Mar. 9, 2008. No inference is intended with respect to the federal income tax treatment of exchanges of dwelling units taking place before Mar. 10, 2008.

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