Development

Category: 1031 Exchange General

  • The Same Taxpayer Requirement in a 1031 Tax Deferred Exchange

    What is the Same Taxpayer Rule in a 1031 Like-Kind Exchange?
    In a 1031 exchange, the taxpayer who owns the relinquished property must be the same taxpayer who takes ownership of the replacement property.  Keep in mind that one of the justifications for tax deferral is that a taxpayer has reported all the incidences of ownership and that the taxpayer’s basis will carry over into the new replacement property.  The taxpayer is only getting deferral, not permanent tax avoidance, and the sheltered gain will be due ultimately upon a future sale of the property without an exchange. If the taxpayer were to change tax identities within an exchange, there would be no continuity of tax ownership and no reason to afford deferral.
    In addition, the exchange regulations provide that the taxpayer must transfer the relinquished property as well as receive the transfer of the replacement property.  If, for tax purposes, the taxpayer changes its tax identity between the sale and the purchase, then the same taxpayer will not have disposed of and received property.  So, while the same taxpayer requirement will not be found by those words in the regulations, it is very clearly implicit.
    When determining what constitutes “the same taxpayer” the tax identity may be different than the legal title.  It is the tax identity that must be maintained and follow from the relinquished property ownership to the replacement property ownership.  Another way to look at this is whether the selling and buying entities use the same social security number for both properties and does it change to a Federal Tax-Identification Number (FEIN or EIN) from one property to the other. The social security number would typically be used for a single individual’s ownership, including ownership under tax disregarded entities discussed below in more detail. The FEIN number would typically be used for a business or an entity ownership consisting of more than one person or more than one entity, such as a multi-member limited liability company or a partnership.
    Can a Taxpayer Change the Ownership but Maintain the Tax Identity?
    Remember that we are talking about the tax identity, not necessarily the specific name of the title of the property.  So let’s look at some various ways in which a taxpayer can hold title that would preserve the tax identity:

    Hold title in taxpayer’s own name
    Hold title under a single member limited liability company (LLC)
    Hold title as the trustee of a Revocable Living Trust
    Hold title as beneficiary of an Illinois type land trust
    Hold title as a Tenant in Common (TIC)
    Hold title under a Delaware Statutory Trust (DST)

    Holding Title in the Taxpayer’s Own Name
    Using the taxpayer’s own name is the most common form or ownership.  This ownership can be as an individual, LLC, partnership, etc.  There is always a tax identification number associated with this ownership. 
    Holding Title as a Single Member LLC, Trustee of a Revocable Living Trust, or TIC
    Single member LLCs and Self Declarations of Trust (Living Trust) are known as “tax disregarded entities.” These entities are taxed to the party that is the sole member of the LLC or the grantor/beneficiary of the trust.  A TIC is also deemed to be owned by the owner of that Tenant in Common share.  The fact that there are other co-owners of the property has no adverse consequences to the taxpayer being the same taxpayer who sold the property individually.
    Holding Title under a Delaware Statutory Trust
    DSTs themselves are regarded as a trust, however the owner of a DST share is regarded as owning a beneficial interest in the trust.  As such, a person selling as an individual but buying through a DST interest is still treated as the same taxpayer assuming the beneficial interest is held in the same individual taxpayer’s name.  In 2004,

  • The Same Taxpayer Requirement in a 1031 Tax Deferred Exchange

    What is the Same Taxpayer Rule in a 1031 Like-Kind Exchange?
    In a 1031 exchange, the taxpayer who owns the relinquished property must be the same taxpayer who takes ownership of the replacement property.  Keep in mind that one of the justifications for tax deferral is that a taxpayer has reported all the incidences of ownership and that the taxpayer’s basis will carry over into the new replacement property.  The taxpayer is only getting deferral, not permanent tax avoidance, and the sheltered gain will be due ultimately upon a future sale of the property without an exchange. If the taxpayer were to change tax identities within an exchange, there would be no continuity of tax ownership and no reason to afford deferral.
    In addition, the exchange regulations provide that the taxpayer must transfer the relinquished property as well as receive the transfer of the replacement property.  If, for tax purposes, the taxpayer changes its tax identity between the sale and the purchase, then the same taxpayer will not have disposed of and received property.  So, while the same taxpayer requirement will not be found by those words in the regulations, it is very clearly implicit.
    When determining what constitutes “the same taxpayer” the tax identity may be different than the legal title.  It is the tax identity that must be maintained and follow from the relinquished property ownership to the replacement property ownership.  Another way to look at this is whether the selling and buying entities use the same social security number for both properties and does it change to a Federal Tax-Identification Number (FEIN or EIN) from one property to the other. The social security number would typically be used for a single individual’s ownership, including ownership under tax disregarded entities discussed below in more detail. The FEIN number would typically be used for a business or an entity ownership consisting of more than one person or more than one entity, such as a multi-member limited liability company or a partnership.
    Can a Taxpayer Change the Ownership but Maintain the Tax Identity?
    Remember that we are talking about the tax identity, not necessarily the specific name of the title of the property.  So let’s look at some various ways in which a taxpayer can hold title that would preserve the tax identity:

    Hold title in taxpayer’s own name
    Hold title under a single member limited liability company (LLC)
    Hold title as the trustee of a Revocable Living Trust
    Hold title as beneficiary of an Illinois type land trust
    Hold title as a Tenant in Common (TIC)
    Hold title under a Delaware Statutory Trust (DST)

    Holding Title in the Taxpayer’s Own Name
    Using the taxpayer’s own name is the most common form or ownership.  This ownership can be as an individual, LLC, partnership, etc.  There is always a tax identification number associated with this ownership. 
    Holding Title as a Single Member LLC, Trustee of a Revocable Living Trust, or TIC
    Single member LLCs and Self Declarations of Trust (Living Trust) are known as “tax disregarded entities.” These entities are taxed to the party that is the sole member of the LLC or the grantor/beneficiary of the trust.  A TIC is also deemed to be owned by the owner of that Tenant in Common share.  The fact that there are other co-owners of the property has no adverse consequences to the taxpayer being the same taxpayer who sold the property individually.
    Holding Title under a Delaware Statutory Trust
    DSTs themselves are regarded as a trust, however the owner of a DST share is regarded as owning a beneficial interest in the trust.  As such, a person selling as an individual but buying through a DST interest is still treated as the same taxpayer assuming the beneficial interest is held in the same individual taxpayer’s name.  In 2004,

  • The Same Taxpayer Requirement in a 1031 Tax Deferred Exchange

    What is the Same Taxpayer Rule in a 1031 Like-Kind Exchange?
    In a 1031 exchange, the taxpayer who owns the relinquished property must be the same taxpayer who takes ownership of the replacement property.  Keep in mind that one of the justifications for tax deferral is that a taxpayer has reported all the incidences of ownership and that the taxpayer’s basis will carry over into the new replacement property.  The taxpayer is only getting deferral, not permanent tax avoidance, and the sheltered gain will be due ultimately upon a future sale of the property without an exchange. If the taxpayer were to change tax identities within an exchange, there would be no continuity of tax ownership and no reason to afford deferral.
    In addition, the exchange regulations provide that the taxpayer must transfer the relinquished property as well as receive the transfer of the replacement property.  If, for tax purposes, the taxpayer changes its tax identity between the sale and the purchase, then the same taxpayer will not have disposed of and received property.  So, while the same taxpayer requirement will not be found by those words in the regulations, it is very clearly implicit.
    When determining what constitutes “the same taxpayer” the tax identity may be different than the legal title.  It is the tax identity that must be maintained and follow from the relinquished property ownership to the replacement property ownership.  Another way to look at this is whether the selling and buying entities use the same social security number for both properties and does it change to a Federal Tax-Identification Number (FEIN or EIN) from one property to the other. The social security number would typically be used for a single individual’s ownership, including ownership under tax disregarded entities discussed below in more detail. The FEIN number would typically be used for a business or an entity ownership consisting of more than one person or more than one entity, such as a multi-member limited liability company or a partnership.
    Can a Taxpayer Change the Ownership but Maintain the Tax Identity?
    Remember that we are talking about the tax identity, not necessarily the specific name of the title of the property.  So let’s look at some various ways in which a taxpayer can hold title that would preserve the tax identity:

    Hold title in taxpayer’s own name
    Hold title under a single member limited liability company (LLC)
    Hold title as the trustee of a Revocable Living Trust
    Hold title as beneficiary of an Illinois type land trust
    Hold title as a Tenant in Common (TIC)
    Hold title under a Delaware Statutory Trust (DST)

    Holding Title in the Taxpayer’s Own Name
    Using the taxpayer’s own name is the most common form or ownership.  This ownership can be as an individual, LLC, partnership, etc.  There is always a tax identification number associated with this ownership. 
    Holding Title as a Single Member LLC, Trustee of a Revocable Living Trust, or TIC
    Single member LLCs and Self Declarations of Trust (Living Trust) are known as “tax disregarded entities.” These entities are taxed to the party that is the sole member of the LLC or the grantor/beneficiary of the trust.  A TIC is also deemed to be owned by the owner of that Tenant in Common share.  The fact that there are other co-owners of the property has no adverse consequences to the taxpayer being the same taxpayer who sold the property individually.
    Holding Title under a Delaware Statutory Trust
    DSTs themselves are regarded as a trust, however the owner of a DST share is regarded as owning a beneficial interest in the trust.  As such, a person selling as an individual but buying through a DST interest is still treated as the same taxpayer assuming the beneficial interest is held in the same individual taxpayer’s name.  In 2004,

  • 1031 Exchange Rules for Vacation Homes, Primary Residences, and Mixed Use Properties

    It is quite common for clients to call a 1031 exchange company with questions regarding exchanges of their former or future principal residences or vacation homes.  Under what circumstances can these dwellings be used as part of a 1031 exchange?  Do they satisfy the requirement that both the relinquished and replacement properties must be held for investment or for use in a business or trade?  Does some personal use trump the investment use of the property?  This blog is intended to answer these commonly asked questions:

    Under what circumstances can a second home or vacation home constitute relinquished or replacement property for the purposes of a 1031 exchange?
    Can a principal residence be converted into an investment property eligible for 1031 tax deferral upon sale?
    Can a property that has been held for investment be converted to a principal residence and what are the rules when it is sold?
    Can a mixed use property be sold with a personal residence exemption and 1031 exchange deferral?

    Rules for Including a Vacation Home in a 1031 Exchange
    Historically, determining whether a home that was both rented out and used by its owner could be eligible for 1031 tax deferral was difficult to ascertain.  There was some case law but that was a bit inconsistent.  The IRS attempted to provide some definitive guidance regarding some of these questions in the form of Revenue Procedure 2008-16.  As the IRS aptly put it:
    “The Service 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, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under §1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes.”
    This revenue procedure made clear that for a relinquished vacation property to qualify for a 1031 exchange, the property has to be owned by the taxpayer and held as an investment for at least 24 months immediately prior to the exchange.  Additionally, within each of the two 12-month periods prior to the sale, the property must have been rented at fair market value to a person for at least 14 days or more, and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented. 
    The requirements for property to qualify as a 1031 replacement property are very similar.  The property has to be owned by the taxpayer for at least 24 months immediately after the exchange.  Also, within each of the two 12-month periods after the exchange, property must have been rented at fair market value to a person for at least 14 days or more and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented.  The taxpayer is allowed to use the relinquished or replacement property for additional days if the use is for property maintenance or repair.
    Rules for Converting a Personal Residence for a 1031 Exchange
    In many cases, conversion of a personal residence to a property held as an investment or for use in a business or trade “exchange eligible property,” as defined above, may still allow a taxpayer to receive a full exemption of gain pursuant to the rules of Internal Revenue Code Section 121 upon sale of the property.  That Code section provides for an exclusion of gain of up to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly upon the sale of a principal residence.  There is a requirement that during the five-year period immediately preceding the sale, the taxpayer must have used the property as a principal residence for a cumulative period of at least two years. 
    Even if the property has had principal residence use followed by exchange eligible use, the taxpayer does not necessarily have to do an exchange on the investment/business use of the property if the total gain can be sheltered by the §121 allowed exclusions.  So even if during the immediate two years preceding the sale, the property was used as exchange eligible property, the taxpayer may still benefit from the personal residence exclusion.  In the event the gain exceeds the maximums allowed for per IRC Section 121 primary residence, the taxpayer may still be able to shelter the balance via a 1031 exchange, thus combining the benefits of these two code sections.
    Under Revenue Procedure 2008-16 the conversion of the principal residence to an exchange eligible investment property does not disqualify a family member as the tenant.  However, the revenue procedure requires that this should be done at a fair market rental and it must constitute the family member’s personal residence and not the family member’s vacation home.  There are additional rules for the rental of the property by a family member who co-owns the property with the taxpayer.
    Should a taxpayer wish to convert the personal residence to exchange eligible property, the taxpayer must have owned the property for the two years immediately prior to the sale and:

    For each of the years the property must be rented to a person for 14 days or more
    The taxpayer’s personal use has to be limited to no more than 14 days per year or less than 10% of the days per year that property is rented.

    Rules for Converting a 1031 Exchange Property to a Personal Residence
    If the taxpayer’s intent, based upon facts and circumstances at the time of the property acquisition was to hold the property as an investment or for use in a business, the subsequent conversion use of the property to use as a principal residence should not otherwise jeopardize the ability to exchange.  As an example, a taxpayer may wish to exchange into a rental condominium in Florida and upon retirement relocate from a northern state into the condominium as the principal residence.
    If the taxpayer subsequently sells the principal residence, there may be the ability to defer the gain under §121.  However there are some limitations to this deferral upon conversion, otherwise taxpayers might convert exchange property into a principal residence property, sell shortly thereafter, and seek IRC Section 121 primary residence deferral.  These rules require that the property has to be held for at least five years in total with the period of time the property was held as an exchange property included.  The period of time the property was used as an exchange property needs to be backed out of the calculation for the principal residence use deferral.  This calculation is made by using the period of time the property was held as an exchange property as the numerator and the period of time the property was held in total as the denominator.  The resulting fraction or percentage would be applied to the total gain and the resulting dollar amount would not be eligible for a §121 deferral. 
    Take the example of a property owned by a taxpayer for seven years prior to sale, three of which were used as an exchange property and four of which were used as the taxpayer’s principal residence.  Assume that the gain upon sale is $200,000.  Dividing the number of three years by seven years x $200,000 results in the amount of $85,714 which is taxable.
    1031 Exchanges and Mixed Use Properties
    At times, a taxpayer may own a home as the principal residence but part of the property may have been used as an investment or in connection with a business or trade, creating an exchange eligible component.  This is known as a mixed use property.  An example might be a psychologist who sees patients in a home office.  Another example might be a property with a separate coach house that is rented out.  It is quite common for a taxpayer to sell a three flat where the taxpayer uses one unit as the principal residence.  In these instances IRC Section 121 and IRC Section 1031 can both be used to achieve total deferral.    
    There is one caveat with exchanges of mixed use properties, which is that on closing statements there is a tendency to give credits for prorated rent and security deposits to the buyer.  This causes the net amount of proceeds attributable to each property use component to be reduced proportionately.  Technically, those credits only pertain to the exchange eligible portion of the property and should not appear as a credit on the personal residence portion of the sale.
    Summary
    A variety of circumstances surround property that has been or will be exchange eligible and may also have been used or will be used by the taxpayer as a principal residence or vacation home.  Revenue Procedure 2008-16 provides rules regarding vacation homes and exchange eligible property.  Likewise, there are rules under IRC Section 121 for converting exchange property into a personal residence and vice-versa.  Properties that have both a principal residence component as well as an exchange-eligible one can benefit by both the deferral sections, but care should be taken to do proper accounting so that buyer credits affect the exchange eligible portion of the sale only.
     
    Updated 4/18/2022.

  • 1031 Exchange Rules for Vacation Homes, Primary Residences, and Mixed Use Properties

    It is quite common for clients to call a 1031 exchange company with questions regarding exchanges of their former or future principal residences or vacation homes.  Under what circumstances can these dwellings be used as part of a 1031 exchange?  Do they satisfy the requirement that both the relinquished and replacement properties must be held for investment or for use in a business or trade?  Does some personal use trump the investment use of the property?  This blog is intended to answer these commonly asked questions:

    Under what circumstances can a second home or vacation home constitute relinquished or replacement property for the purposes of a 1031 exchange?
    Can a principal residence be converted into an investment property eligible for 1031 tax deferral upon sale?
    Can a property that has been held for investment be converted to a principal residence and what are the rules when it is sold?
    Can a mixed use property be sold with a personal residence exemption and 1031 exchange deferral?

    Rules for Including a Vacation Home in a 1031 Exchange
    Historically, determining whether a home that was both rented out and used by its owner could be eligible for 1031 tax deferral was difficult to ascertain.  There was some case law but that was a bit inconsistent.  The IRS attempted to provide some definitive guidance regarding some of these questions in the form of Revenue Procedure 2008-16.  As the IRS aptly put it:
    “The Service 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, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under §1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes.”
    This revenue procedure made clear that for a relinquished vacation property to qualify for a 1031 exchange, the property has to be owned by the taxpayer and held as an investment for at least 24 months immediately prior to the exchange.  Additionally, within each of the two 12-month periods prior to the sale, the property must have been rented at fair market value to a person for at least 14 days or more, and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented. 
    The requirements for property to qualify as a 1031 replacement property are very similar.  The property has to be owned by the taxpayer for at least 24 months immediately after the exchange.  Also, within each of the two 12-month periods after the exchange, property must have been rented at fair market value to a person for at least 14 days or more and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented.  The taxpayer is allowed to use the relinquished or replacement property for additional days if the use is for property maintenance or repair.
    Rules for Converting a Personal Residence for a 1031 Exchange
    In many cases, conversion of a personal residence to a property held as an investment or for use in a business or trade “exchange eligible property,” as defined above, may still allow a taxpayer to receive a full exemption of gain pursuant to the rules of Internal Revenue Code Section 121 upon sale of the property.  That Code section provides for an exclusion of gain of up to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly upon the sale of a principal residence.  There is a requirement that during the five-year period immediately preceding the sale, the taxpayer must have used the property as a principal residence for a cumulative period of at least two years. 
    Even if the property has had principal residence use followed by exchange eligible use, the taxpayer does not necessarily have to do an exchange on the investment/business use of the property if the total gain can be sheltered by the §121 allowed exclusions.  So even if during the immediate two years preceding the sale, the property was used as exchange eligible property, the taxpayer may still benefit from the personal residence exclusion.  In the event the gain exceeds the maximums allowed for per IRC Section 121 primary residence, the taxpayer may still be able to shelter the balance via a 1031 exchange, thus combining the benefits of these two code sections.
    Under Revenue Procedure 2008-16 the conversion of the principal residence to an exchange eligible investment property does not disqualify a family member as the tenant.  However, the revenue procedure requires that this should be done at a fair market rental and it must constitute the family member’s personal residence and not the family member’s vacation home.  There are additional rules for the rental of the property by a family member who co-owns the property with the taxpayer.
    Should a taxpayer wish to convert the personal residence to exchange eligible property, the taxpayer must have owned the property for the two years immediately prior to the sale and:

    For each of the years the property must be rented to a person for 14 days or more
    The taxpayer’s personal use has to be limited to no more than 14 days per year or less than 10% of the days per year that property is rented.

    Rules for Converting a 1031 Exchange Property to a Personal Residence
    If the taxpayer’s intent, based upon facts and circumstances at the time of the property acquisition was to hold the property as an investment or for use in a business, the subsequent conversion use of the property to use as a principal residence should not otherwise jeopardize the ability to exchange.  As an example, a taxpayer may wish to exchange into a rental condominium in Florida and upon retirement relocate from a northern state into the condominium as the principal residence.
    If the taxpayer subsequently sells the principal residence, there may be the ability to defer the gain under §121.  However there are some limitations to this deferral upon conversion, otherwise taxpayers might convert exchange property into a principal residence property, sell shortly thereafter, and seek IRC Section 121 primary residence deferral.  These rules require that the property has to be held for at least five years in total with the period of time the property was held as an exchange property included.  The period of time the property was used as an exchange property needs to be backed out of the calculation for the principal residence use deferral.  This calculation is made by using the period of time the property was held as an exchange property as the numerator and the period of time the property was held in total as the denominator.  The resulting fraction or percentage would be applied to the total gain and the resulting dollar amount would not be eligible for a §121 deferral. 
    Take the example of a property owned by a taxpayer for seven years prior to sale, three of which were used as an exchange property and four of which were used as the taxpayer’s principal residence.  Assume that the gain upon sale is $200,000.  Dividing the number of three years by seven years x $200,000 results in the amount of $85,714 which is taxable.
    1031 Exchanges and Mixed Use Properties
    At times, a taxpayer may own a home as the principal residence but part of the property may have been used as an investment or in connection with a business or trade, creating an exchange eligible component.  This is known as a mixed use property.  An example might be a psychologist who sees patients in a home office.  Another example might be a property with a separate coach house that is rented out.  It is quite common for a taxpayer to sell a three flat where the taxpayer uses one unit as the principal residence.  In these instances IRC Section 121 and IRC Section 1031 can both be used to achieve total deferral.    
    There is one caveat with exchanges of mixed use properties, which is that on closing statements there is a tendency to give credits for prorated rent and security deposits to the buyer.  This causes the net amount of proceeds attributable to each property use component to be reduced proportionately.  Technically, those credits only pertain to the exchange eligible portion of the property and should not appear as a credit on the personal residence portion of the sale.
    Summary
    A variety of circumstances surround property that has been or will be exchange eligible and may also have been used or will be used by the taxpayer as a principal residence or vacation home.  Revenue Procedure 2008-16 provides rules regarding vacation homes and exchange eligible property.  Likewise, there are rules under IRC Section 121 for converting exchange property into a personal residence and vice-versa.  Properties that have both a principal residence component as well as an exchange-eligible one can benefit by both the deferral sections, but care should be taken to do proper accounting so that buyer credits affect the exchange eligible portion of the sale only.
     
    Updated 4/18/2022.

  • 1031 Exchange Rules for Vacation Homes, Primary Residences, and Mixed Use Properties

    It is quite common for clients to call a 1031 exchange company with questions regarding exchanges of their former or future principal residences or vacation homes.  Under what circumstances can these dwellings be used as part of a 1031 exchange?  Do they satisfy the requirement that both the relinquished and replacement properties must be held for investment or for use in a business or trade?  Does some personal use trump the investment use of the property?  This blog is intended to answer these commonly asked questions:

    Under what circumstances can a second home or vacation home constitute relinquished or replacement property for the purposes of a 1031 exchange?
    Can a principal residence be converted into an investment property eligible for 1031 tax deferral upon sale?
    Can a property that has been held for investment be converted to a principal residence and what are the rules when it is sold?
    Can a mixed use property be sold with a personal residence exemption and 1031 exchange deferral?

    Rules for Including a Vacation Home in a 1031 Exchange
    Historically, determining whether a home that was both rented out and used by its owner could be eligible for 1031 tax deferral was difficult to ascertain.  There was some case law but that was a bit inconsistent.  The IRS attempted to provide some definitive guidance regarding some of these questions in the form of Revenue Procedure 2008-16.  As the IRS aptly put it:
    “The Service 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, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under §1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes.”
    This revenue procedure made clear that for a relinquished vacation property to qualify for a 1031 exchange, the property has to be owned by the taxpayer and held as an investment for at least 24 months immediately prior to the exchange.  Additionally, within each of the two 12-month periods prior to the sale, the property must have been rented at fair market value to a person for at least 14 days or more, and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented. 
    The requirements for property to qualify as a 1031 replacement property are very similar.  The property has to be owned by the taxpayer for at least 24 months immediately after the exchange.  Also, within each of the two 12-month periods after the exchange, property must have been rented at fair market value to a person for at least 14 days or more and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented.  The taxpayer is allowed to use the relinquished or replacement property for additional days if the use is for property maintenance or repair.
    Rules for Converting a Personal Residence for a 1031 Exchange
    In many cases, conversion of a personal residence to a property held as an investment or for use in a business or trade “exchange eligible property,” as defined above, may still allow a taxpayer to receive a full exemption of gain pursuant to the rules of Internal Revenue Code Section 121 upon sale of the property.  That Code section provides for an exclusion of gain of up to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly upon the sale of a principal residence.  There is a requirement that during the five-year period immediately preceding the sale, the taxpayer must have used the property as a principal residence for a cumulative period of at least two years. 
    Even if the property has had principal residence use followed by exchange eligible use, the taxpayer does not necessarily have to do an exchange on the investment/business use of the property if the total gain can be sheltered by the §121 allowed exclusions.  So even if during the immediate two years preceding the sale, the property was used as exchange eligible property, the taxpayer may still benefit from the personal residence exclusion.  In the event the gain exceeds the maximums allowed for per IRC Section 121 primary residence, the taxpayer may still be able to shelter the balance via a 1031 exchange, thus combining the benefits of these two code sections.
    Under Revenue Procedure 2008-16 the conversion of the principal residence to an exchange eligible investment property does not disqualify a family member as the tenant.  However, the revenue procedure requires that this should be done at a fair market rental and it must constitute the family member’s personal residence and not the family member’s vacation home.  There are additional rules for the rental of the property by a family member who co-owns the property with the taxpayer.
    Should a taxpayer wish to convert the personal residence to exchange eligible property, the taxpayer must have owned the property for the two years immediately prior to the sale and:

    For each of the years the property must be rented to a person for 14 days or more
    The taxpayer’s personal use has to be limited to no more than 14 days per year or less than 10% of the days per year that property is rented.

    Rules for Converting a 1031 Exchange Property to a Personal Residence
    If the taxpayer’s intent, based upon facts and circumstances at the time of the property acquisition was to hold the property as an investment or for use in a business, the subsequent conversion use of the property to use as a principal residence should not otherwise jeopardize the ability to exchange.  As an example, a taxpayer may wish to exchange into a rental condominium in Florida and upon retirement relocate from a northern state into the condominium as the principal residence.
    If the taxpayer subsequently sells the principal residence, there may be the ability to defer the gain under §121.  However there are some limitations to this deferral upon conversion, otherwise taxpayers might convert exchange property into a principal residence property, sell shortly thereafter, and seek IRC Section 121 primary residence deferral.  These rules require that the property has to be held for at least five years in total with the period of time the property was held as an exchange property included.  The period of time the property was used as an exchange property needs to be backed out of the calculation for the principal residence use deferral.  This calculation is made by using the period of time the property was held as an exchange property as the numerator and the period of time the property was held in total as the denominator.  The resulting fraction or percentage would be applied to the total gain and the resulting dollar amount would not be eligible for a §121 deferral. 
    Take the example of a property owned by a taxpayer for seven years prior to sale, three of which were used as an exchange property and four of which were used as the taxpayer’s principal residence.  Assume that the gain upon sale is $200,000.  Dividing the number of three years by seven years x $200,000 results in the amount of $85,714 which is taxable.
    1031 Exchanges and Mixed Use Properties
    At times, a taxpayer may own a home as the principal residence but part of the property may have been used as an investment or in connection with a business or trade, creating an exchange eligible component.  This is known as a mixed use property.  An example might be a psychologist who sees patients in a home office.  Another example might be a property with a separate coach house that is rented out.  It is quite common for a taxpayer to sell a three flat where the taxpayer uses one unit as the principal residence.  In these instances IRC Section 121 and IRC Section 1031 can both be used to achieve total deferral.    
    There is one caveat with exchanges of mixed use properties, which is that on closing statements there is a tendency to give credits for prorated rent and security deposits to the buyer.  This causes the net amount of proceeds attributable to each property use component to be reduced proportionately.  Technically, those credits only pertain to the exchange eligible portion of the property and should not appear as a credit on the personal residence portion of the sale.
    Summary
    A variety of circumstances surround property that has been or will be exchange eligible and may also have been used or will be used by the taxpayer as a principal residence or vacation home.  Revenue Procedure 2008-16 provides rules regarding vacation homes and exchange eligible property.  Likewise, there are rules under IRC Section 121 for converting exchange property into a personal residence and vice-versa.  Properties that have both a principal residence component as well as an exchange-eligible one can benefit by both the deferral sections, but care should be taken to do proper accounting so that buyer credits affect the exchange eligible portion of the sale only.
     
    Updated 4/18/2022.

  • IRC Section 1031 Exchange Qualified Use Requirements

    We recently examined the duration a taxpayer must hold a relinquished and replacement property to satisfy the requirement that exchanged assets must be held for investment or used in a business or trade.  The conclusion was that there is no specific time limit for an asset to be deemed to having been held, rather it is a facts and circumstances test.  In this post, we will look into the issue of “qualified use” as another key element in a successful tax deferred exchange.
    IRC Section 1031(a)(1) provides “In general no gain or loss shall be recognized on the exchange of property held for productive use in a 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”. 
    Let’s look at some examples where the productive or qualified use requirement may, or may not, apply in a 1031 exchange.
    Vacation Homes and Qualified Use
    A taxpayer’s vacation home or second residence can be eligible for a 1031 exchange if specific requirements are met. The property must have been held for investment for at least 24 months prior to the exchange. Additionally, the property must have been rented out at fair market value for a minimum of 14 days within each of the 12 months and the taxpayer cannot have used the property personally for more than 14 days, or 10% of the days the property was rented, within each of the 12 month periods. 
    Taxpayer Occupied Multi-Family Property and Qualified Use
    A multifamily property such as a two flat or three flat, where the owner lives in one unit and rents out the other unit(s) can be the subject of an exchange of the investment portion.  The sale would be split where the taxpayer could receive directly the net proceeds pertaining to the personal use unit and could cause the net proceeds pertaining to the investment unit(s) to go to fund the exchange account. In most cases, the gain associated with the owner occupied unit could also be deferred under IRC Section 121, the Code section dealing with the sale of a personal residence. 
    Keep in mind that the assignment of contract rights under the relinquished property agreement must be modified to show what percentage interest of the whole property will be the subject of the assignment to the qualified intermediary.
    Taxpayer Occupied Farm Land and Qualified Use
    Similarly, exchanges of farmland are very common.  Often the personal residence of the owner sits on the farmland.  Again, as in the other examples, the percentage of the land that is used for farming can be exchanged and the percentage used for the dwelling can be sheltered under IRC Section 121.
    Mixed Use Personal Residences and Qualified Use
    There are taxpayers who have mixed use of their personal residence.  An example of this might be a psychologist who uses a room in the home as the office to meet with clients.  If the square footage of this room is 10% of the entire residence than a 10% interest in the relinquished property could be sold as part of an exchange. 
    Death of a Taxpayer and Qualified Use
    As the saying goes, the only sure things in life are death and taxes.  We have covered taxes above, so let’s look at the effect of the death of the taxpayer on the issue of qualified use.  If a taxpayer dies prior to the anticipated sale of relinquished property, the heirs get the property with a stepped up basis and would not have a need for tax deferral.  However in the event a taxpayer dies after the start of an exchange and the sale of the relinquished property, the gain would be due without an acquisition of replacement property.  Despite the estate not having qualified use of the property itself, there are various favorable IRS rulings allowing the estate to acquire the replacement property and defer the gain recognition.
    Summary
    The exchange rules require that the relinquished and replacement properties be ones that are held for productive use in a business or trade or as an investment. This “productive use,” often referred to ‘qualified use” can sometimes cause confusion where there is both a personal use of a property and also a qualified use of part of the same property.  In most cases, the qualified use portion of the property can be separated and be the subject of a §1031 exchange.
     
    Updated 4/12/2022.

  • IRC Section 1031 Exchange Qualified Use Requirements

    We recently examined the duration a taxpayer must hold a relinquished and replacement property to satisfy the requirement that exchanged assets must be held for investment or used in a business or trade.  The conclusion was that there is no specific time limit for an asset to be deemed to having been held, rather it is a facts and circumstances test.  In this post, we will look into the issue of “qualified use” as another key element in a successful tax deferred exchange.
    IRC Section 1031(a)(1) provides “In general no gain or loss shall be recognized on the exchange of property held for productive use in a 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”. 
    Let’s look at some examples where the productive or qualified use requirement may, or may not, apply in a 1031 exchange.
    Vacation Homes and Qualified Use
    A taxpayer’s vacation home or second residence can be eligible for a 1031 exchange if specific requirements are met. The property must have been held for investment for at least 24 months prior to the exchange. Additionally, the property must have been rented out at fair market value for a minimum of 14 days within each of the 12 months and the taxpayer cannot have used the property personally for more than 14 days, or 10% of the days the property was rented, within each of the 12 month periods. 
    Taxpayer Occupied Multi-Family Property and Qualified Use
    A multifamily property such as a two flat or three flat, where the owner lives in one unit and rents out the other unit(s) can be the subject of an exchange of the investment portion.  The sale would be split where the taxpayer could receive directly the net proceeds pertaining to the personal use unit and could cause the net proceeds pertaining to the investment unit(s) to go to fund the exchange account. In most cases, the gain associated with the owner occupied unit could also be deferred under IRC Section 121, the Code section dealing with the sale of a personal residence. 
    Keep in mind that the assignment of contract rights under the relinquished property agreement must be modified to show what percentage interest of the whole property will be the subject of the assignment to the qualified intermediary.
    Taxpayer Occupied Farm Land and Qualified Use
    Similarly, exchanges of farmland are very common.  Often the personal residence of the owner sits on the farmland.  Again, as in the other examples, the percentage of the land that is used for farming can be exchanged and the percentage used for the dwelling can be sheltered under IRC Section 121.
    Mixed Use Personal Residences and Qualified Use
    There are taxpayers who have mixed use of their personal residence.  An example of this might be a psychologist who uses a room in the home as the office to meet with clients.  If the square footage of this room is 10% of the entire residence than a 10% interest in the relinquished property could be sold as part of an exchange. 
    Death of a Taxpayer and Qualified Use
    As the saying goes, the only sure things in life are death and taxes.  We have covered taxes above, so let’s look at the effect of the death of the taxpayer on the issue of qualified use.  If a taxpayer dies prior to the anticipated sale of relinquished property, the heirs get the property with a stepped up basis and would not have a need for tax deferral.  However in the event a taxpayer dies after the start of an exchange and the sale of the relinquished property, the gain would be due without an acquisition of replacement property.  Despite the estate not having qualified use of the property itself, there are various favorable IRS rulings allowing the estate to acquire the replacement property and defer the gain recognition.
    Summary
    The exchange rules require that the relinquished and replacement properties be ones that are held for productive use in a business or trade or as an investment. This “productive use,” often referred to ‘qualified use” can sometimes cause confusion where there is both a personal use of a property and also a qualified use of part of the same property.  In most cases, the qualified use portion of the property can be separated and be the subject of a §1031 exchange.
     
    Updated 4/12/2022.

  • IRC Section 1031 Exchange Qualified Use Requirements

    We recently examined the duration a taxpayer must hold a relinquished and replacement property to satisfy the requirement that exchanged assets must be held for investment or used in a business or trade.  The conclusion was that there is no specific time limit for an asset to be deemed to having been held, rather it is a facts and circumstances test.  In this post, we will look into the issue of “qualified use” as another key element in a successful tax deferred exchange.
    IRC Section 1031(a)(1) provides “In general no gain or loss shall be recognized on the exchange of property held for productive use in a 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”. 
    Let’s look at some examples where the productive or qualified use requirement may, or may not, apply in a 1031 exchange.
    Vacation Homes and Qualified Use
    A taxpayer’s vacation home or second residence can be eligible for a 1031 exchange if specific requirements are met. The property must have been held for investment for at least 24 months prior to the exchange. Additionally, the property must have been rented out at fair market value for a minimum of 14 days within each of the 12 months and the taxpayer cannot have used the property personally for more than 14 days, or 10% of the days the property was rented, within each of the 12 month periods. 
    Taxpayer Occupied Multi-Family Property and Qualified Use
    A multifamily property such as a two flat or three flat, where the owner lives in one unit and rents out the other unit(s) can be the subject of an exchange of the investment portion.  The sale would be split where the taxpayer could receive directly the net proceeds pertaining to the personal use unit and could cause the net proceeds pertaining to the investment unit(s) to go to fund the exchange account. In most cases, the gain associated with the owner occupied unit could also be deferred under IRC Section 121, the Code section dealing with the sale of a personal residence. 
    Keep in mind that the assignment of contract rights under the relinquished property agreement must be modified to show what percentage interest of the whole property will be the subject of the assignment to the qualified intermediary.
    Taxpayer Occupied Farm Land and Qualified Use
    Similarly, exchanges of farmland are very common.  Often the personal residence of the owner sits on the farmland.  Again, as in the other examples, the percentage of the land that is used for farming can be exchanged and the percentage used for the dwelling can be sheltered under IRC Section 121.
    Mixed Use Personal Residences and Qualified Use
    There are taxpayers who have mixed use of their personal residence.  An example of this might be a psychologist who uses a room in the home as the office to meet with clients.  If the square footage of this room is 10% of the entire residence than a 10% interest in the relinquished property could be sold as part of an exchange. 
    Death of a Taxpayer and Qualified Use
    As the saying goes, the only sure things in life are death and taxes.  We have covered taxes above, so let’s look at the effect of the death of the taxpayer on the issue of qualified use.  If a taxpayer dies prior to the anticipated sale of relinquished property, the heirs get the property with a stepped up basis and would not have a need for tax deferral.  However in the event a taxpayer dies after the start of an exchange and the sale of the relinquished property, the gain would be due without an acquisition of replacement property.  Despite the estate not having qualified use of the property itself, there are various favorable IRS rulings allowing the estate to acquire the replacement property and defer the gain recognition.
    Summary
    The exchange rules require that the relinquished and replacement properties be ones that are held for productive use in a business or trade or as an investment. This “productive use,” often referred to ‘qualified use” can sometimes cause confusion where there is both a personal use of a property and also a qualified use of part of the same property.  In most cases, the qualified use portion of the property can be separated and be the subject of a §1031 exchange.
     
    Updated 4/12/2022.

  • 1031 Drop and Swap out of a Partnership or LLC

    Can a partner or member trade their share of a property interest upon sale?
    One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself.  The section generally provides
    “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like kind which is held for productive use in trade or business or for investment”.
    However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.”  As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members. 
    While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share.  The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
    How is a 1031 drop and swap done?
    A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
    To date the IRS has not adopted this position.  If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
    IRS Form 1065 U.S. Return of Partnership Income
    In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.”  Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis. 
    As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange.  Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
    Underlying Loan Considerations
    When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member.  As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member.  In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
    Almost all loans secured by property contain “due on transfer” clauses.  So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents.  This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
    Deemed Partnership
    There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership.  This would negate a drop and swap.  Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs.  The least amount of management by the co-owners is helpful to avoid partnership characterization.  Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property. 
    For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship.  The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership.   It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible.  Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
    Summary
    The possibility of structuring of a