Author: Matthew Riley
Matthew Riley is an attorney with Bona Law, primarily focused on antitrust, commercial litigation, real-estate, and federal administrative law.
Does property that started off as non-qualifying (i.e. primary residence), but over time has changed its character to fit a qualifying purpose fit within the requirements of Section 1031?
Does property used concurrently for both non-qualifying and qualifying purposes, for example a primary residence, a part of which functions as an office space, qualify as Section 1031 property?
Over time the purposes a property serves can change or multiply. When this occurs, the applicable tax rules may change as well. For example, a primary residence may later become rental property and convert to a business or investment purpose. Or, perhaps the property owner devotes part of their residence for use in a business.
The frequency of questions raised in relation to primary residences and whether or not such properties qualify for a Section 1031 Exchange has spurred the IRS to compose many well-developed tax rules pertaining to these circumstances.
These tax rules, though involving the disposition of Section 1031 property, primarily center upon two other issues:
The first concerns Section 121’s applicability to a Section 1031 Exchange; and the second instructs how to allocate and treat gains recognized in that Exchange.
We will take up the second part, categorizing and calculating taxable gains, later. Here we focus on the initial requirements that must be met before a primary residence can be included in a Section 1031 Like-Kind Exchange.
Section 121 applies when a taxpayer’s primary residence is sold [exchanged] and treats taxable gains from that exchange differently than Section 1031. That is, Section 121 excludes taxable gains from a sale, up to $250,000 for a single taxpayer ($500,000 for those filing taxes jointly), from taxation. This tax-free treatment of gains under Section 121 for primary residences differs from the tax-deferral treatment for business/investment properties under Section 1031. Under certain circumstances, a taxpayer may be able to enjoy the tax advantages of both rules for the same property.
Generally, Revenue Ruling 59-229 disqualifies primary residences from a Section 1031 Like-Kind Exchange. Revenue Procedure 2005-14, however, allows the Exchanger to use such property in an exchange when the property’s use as a primary residence is either concurrent or consecutive to its use for a qualifying business/investment purpose under Section 1031.
To qualify for tax-free and tax-deferral treatments under Section 121 and Section 1031, respectively, two conditions must be met. First, the property must be held as the Exchanger’s primary residence for at least 2 years during a 5 year period ending on the date of the sale or exchange. And, secondly, at the time of the sale or exchange, the Exchanger must have held the property long enough to establish and demonstrate an intention to use the relinquished property for a qualifying business or investment purpose.
For many, the second condition raises the question, How long does it take to establish a demonstrable intention to use a property for a qualifying business or investment purpose? Unlike the first condition, which outlines a specific time requirement, the IRS does not provide the same bright-line holding period for the second condition. Rather, whether the Exchanger has held the property long enough to establish the proper intention is determined on a case-by-case basis. Case-law, legislative history, and heuristics provide guidance to determine whether the required holding period to establish business or investment intention has passed. You should consider the following: