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:
(1) In 1984 the IRS wrote and delivered Private Letter Ruling 8429039. This letter was in response to one written by an individual referred to as “T”. “T” owned property which he used as his primary residence until 1981, when he move out. Since the beginning of 1983, “T” rented his former residence to an unrelated party. In his 1984 letter, “T” asked the IRS whether he could use this property in a Section 1031 Like-Kind Exchange for a beach house, which would be used as rental property for a 2-year period following the proposed exchange. In response, the IRS wrote that holding rental property for a minimum of 2 years is sufficient to meet the holding period test prescribed by Section 1031, requiring that property be held either for productive use in a trade or business or for investment. Please note, however, that under Section 6110(j) of the Tax Code, Private Letter Rulings (PLR) can only be applied to the peculiar facts and circumstances faced by the individual writing the initial letter and cannot be cited or used as precedent for others. Therefore, although this letter may be prescriptive of what the IRS generally requires, you should understand the limitations such letters have.
(2) In 1989, included within HR 3150, Congress proposed a 1-year holding period during which property could be held for productive use in a trade or business or for investment, and thereafter qualify for a Section 1031 Like-Kind Exchange. Although this proposal was never integrated into the Tax Code, tax advisors common rely upon it while advising when property qualifies for an exchange. An additional rationale for reliance on and application of this proposed 1-year holding period by tax advisors is the fact that such property will be categorized as qualifying property on an Exchanger’s tax return for two consecutive years. In part, therefore, this 1-year holding period dovetails with the 2-year holding period articulated in PLR 8429039 above.
When the sufficiency of a relinquished or replacement property’s holding period is questioned by the IRS, an Exchanger’s tax returns are consulted. If an Exchanger holds property continuously for 1-year, during which they use it in a business or for investment, the property’s income will be recorded on tax returns over each of the next two years. Tax returns are evidence showing whether and how much income a property produces, and thereby helps establish an Exchanger’s intention towards that property. As income production for a property is shown on tax returns over a 2-year period, one could argue, the Exchanger has properly held the property for a qualifying purpose for that period.
(3) Other times, courts have radically deviated from the holding periods outlined above. In 1953, in the case Allegheny County Auto Mart v. C.I.R., the Court approved property for an exchange when it was held for only five days. Whereas in 1967, in Klarkowski v. Commissioner, the Tax Court ruled that property held for six years was disqualified for a Like-Kind Exchange.
In Summary: The time period required to establish the requisite intent to hold a property for a qualified purpose is determined on a case-by-case basis. Although the IRS provides some general guidance, there is currently no universal rule or safe harbor one can use to ensure their property meets what Section 1031 requires. It is important to obtain the assistance of a tax or legal professional early on, who can work with you to establish a secure basis supported by evidence demonstrating the requisite intent to hold property for productive use.
INTRODUCTION – GOLDEN RULE TO REAL ESTATE INVESTMENT
PART 1 – THE RELINQUISHED PROPERTY (SOLD PROPERTY) MUST HAVE BEEN HELD BY THE EXCHANGER FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMEST PURPOSES.
- PART 1.1 – Does the Property Qualify as Investment Property for a Section 1031 Exchange?
- PART 1.2 – The Golden Rule of Real Estate Investing: How Long Must Property Be Investment Property To Qualify for Section 1031?
- PART 1.3 – How do you characterize vacant and unproductive land, which is not used for personal enjoyment nor in furtherance of any trade or business purpose?
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.
PART 3 – BOTH THE RELINQUISHED AND REPLACEMENT PROPERTY MUST HAVE A NATURE AND CHARACTER THAT IS “LIKE-KIND” WITH THE OTHER.
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