A 1031 exchange is a capital gain tax deferral strategy that must follow strict guidelines. 1031 exchanges are routinely used by individuals, trusts, limited liability companies and corporations to defer short and long term federal and state capital gain and depreciation recapture taxes when selling and replacing real property held for productive use of a business or for investment. The 1031 exchange is viewed as providing additional working capital or an interest free loan that would otherwise be paid as a tax. The deferred tax is due when the replacement property is sold or can be deferred indefinitely in another 1031 exchange.
Once the replacement property is held as an investment and the suggested two year hold time is satisfied, the property can be converted to a primary residence. By converting to a primary residence a portion of the recognized gain or tax due when selling, after a minimum hold of five years with two of the three years as a primary, can be absorbed by the Section 121 $250,000/$500,000 exclusion. Depreciation recapture and aggregate time held as an investment are not eligible for the exclusion.
Hold Time
Revenue Procedure 2008-16 provides a two year “safe harbor” rental rule for replacement properties where the Internal Revenue Service will not challenge whether the vacation home qualifies as property held for productive use in a business or for investment. The “safe harbor” is effective for exchanges occurring on or after March 10, 2008 and applies only to determining whether property qualifies for property held for productive use in a business or for investment under the 1031 exchange Regulations.
Divorce
So what happens if a couple who recently acquired an investment rental property in a 1031 exchange and one of the two wants to occupy as their primary residence in less than the two year holding period? Given the hold time is outside the “safe harbor” of two years, the courts apply a subjective test as to the taxpayer’s intent at the time the replacement property was acquired.
Tax attorney David Shechtman of Drinker, Biddle & Reath provided the following review.
“In Reesink v. Comm’r, T.C. Memo 2012-118, the Tax Court approved an exchange where the taxpayers converted their replacement property into a personal residence some eight months after acquisition. In that case, the taxpayers demonstrated a clear investment intent at the time of acquisition and that they converted the property to a personal residence only because of unforeseen circumstances (financial setbacks which forced them to sell their more expensive residence and “downsize” into the replacement property). If the husband and wife can demonstrate investment intent and that conversion is occurring because of unforeseen circumstances, they should be okay.
Unforeseen Circumstances
Unforeseen circumstances are when the taxpayer fails to meet the original intent by reason of a change in the location of employment, health, or, to the extent provided in the Regulations. This also applies to a “mixed use” property where the taxpayer utilizes a part of the property as their primary residence and the other portion as an investment property, such as a Bed and Breakfast, farm, or a duplex. The portion used as the primary residence is eligible for the Section 121 exclusion while the portion held as an investment property is eligible for Section 1031 tax deferral. To qualify for the Section 121 exclusion, the taxpayer must hold the principal residence for periods totaling two years or more over a five year period. The exclusion is available once every two years. If the taxpayer fails to meet the two year ownership and use requirements, then a prorated fraction of the exclusion may be taken given the unforeseen circumstances.
When considering selling a primary residence converted from a 1031 exchange replacement property, visit with your CPA to understand the tax consequences. If you have a question regarding a 1031 exchange, please click here to ask a question.
