Articles Posted in Tax Benefits of Real Estate

Author: Matthew Riley

PART 2 – The exchanger must intend to hold the replacement property (acquired property) for productive use in a trade or business or for investment purposes.

In Part 1 of this blog series about 1031 like-kind exchanges, we discussed a real estate investor’s relinquished property (the property an investor is selling), and the requirements such property must meet under Section 1031 to qualify for a like-kind exchange.

If an exchanger’s relinquished property meets Section 1031 requirements, then the next set of questions involve the replacement property, which we discuss, here, in Part 2.

One central inquiry is to investigate the exchanger’s intention in acquiring and using the replacement property.  For an exchange to receive tax-deferred treatment, the exchanger must intend to predominantly use the replacement property in furtherance of a trade or business, or as investment property.

Many of the same issues raised in Part 1 about relinquished properties are the same for replacement properties.  Therefore, our discussion about how requisite intent for relinquished property also applies for replacement property.

Here, in Part 2, I will focus attention on particular holding requirements for replacement properties, highlighting two things:

First, a safe-harbor provision for a specific and common type of replacement property––secondary and vacation homes; and secondly, specific requirements unique to replacement property, which the exchanger must meet when selecting such properties.

(a)      Safe Harbor for replacement properties the exchanger intends to use as a second residence or vacation home?

The safe-harbor requirements for secondary residences or vacation homes are the same as I articulated for relinquished secondary or vacation homes. See Part 1.1. For these types of property, Revenue Procedure 2008-16 provides that if the exchanger meets its requirements it has established the requisite intent for the replacement property.

Under the safe-harbor requirements, the exchanger must own the home for two years immediately after the exchange, and for each of those years, or 12-month periods, the Exchanger must both:

(1) Rent the unit at a fair market rate for 14 or more days; AND

(2) Restrict their personal use to the greater of 14 days – OR – 10% of the number of days it was rented at a fair market rate within that 12 month period.

An investor must follow these requirements to defer their taxes under Section 1031.

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Author: Matthew Riley

 How do you characterize vacant and unproductive land that is not used for personal enjoyment nor in furtherance of any trade or business purpose?

As we described in a prior article, for property to qualify for a Like-Kind Exchange the real estate investor must hold it for productive use in a trade or business, or for investment purposes.  But what about property that is unproductive, meaning that it does not provide any profitable income to the owner, or that perhaps even creates losses for them?  What about acquired property that an owner has left untouched or unimproved?

You can read our summary of 1031 Exchanges here. You can read our articles about the tax advantages of real estate here.

Treasury Regulation 1.1031(a)-1(b) explains that “Like-Kind” refers to the “nature of character of the property and not to its grade or quality.”  The regulation further states that “[o]ne kind or class or property may not, under [Section 1031], be exchanged for property of a different kind or class.”

IRS Publication 544 outlines different kinds or classes of property eligible for like-kind exchanges.  Real estate is one kind or class of property, but other property classes exist. The IRS, for example, has created general asset classes for personal property– some of these include the following:

1. Asset Class 00.12 – Information systems, such as computers and peripheral equipment.
2. Asset Class 00.21 – Airplanes (airframes and engines), except planes used in commercial or contract carrying of passengers or friend, and all helicopters (airframes and engines).
3. Asset Class 00.23 – Buses

What Treasury Regulation 1.1031(a)-1(b) does is restrict property exchanges between any two different and distinct classes– an office building considered to be in the real estate class cannot be exchange for a Learjet 85, considered to be in the airplane class or asset class 00.21; The IBM Sequoia supercomputer in the asset class 00.12 cannot be exchanged for a Justin Bieber Tour Bus in the asset class 00.23.

In other words, the IRS is talking about apples and oranges.  Apples can be exchanged for any other apple because they are the same kind of fruit.  But you cannot exchange an apple for an orange, because these are two different types or classes of fruit.  But again, any apple can be exchanged for any other apple.  A Red Delicious apple can be exchanged for a Granny Smith or Fiji; a rotten apple on the ground can be exchanged for one picked from the apple tree.  The reason this analogy works is because the exchange is occurring within the general class of apples, and the differences that exist are due to the variety of types and qualities existing between any two apples within that class.

Under the general and broad property class, “real estate”, there are countless types and qualities of real estate. The IRS is not concerned with the peculiar qualities of the properties being exchanged, whether the property is a warehouse or pasture, profitable or not to the owner, they are only looking to see whether the properties are both classified as real estate.  Whether the land is vacant or unproductive, therefore, is not material to whether the property is eligible for an exchange.

There are, however, two important caveats to this general rule:

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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?

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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:

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