The federal and state capital gain and depreciation recapture tax deferral 1031 exchange strategy is recognized by the Department of the Treasury and enforced by the Internal Revenue Service (IRS). The Internal Revenue 1031 Code applies to real, tangible and intangible personal property held in the productive use of a business or investment. Real property includes land, single family residential rentals, condominiums, commercial property and oil and gas royalties. Any tangible personal property, such as aircraft, furniture, cars, trucks, equipment, railroad cars and locomotives, livestock, artwork, gold and silver bullion, vintage sport cars and collectibles, are eligible for the tax deferral. Intangible property includes franchise rights, TV and Radio licenses, fishing permits and patents to name a few.
Vacation Property
Properties that are not eligible for a 1031 exchange include a primary residence, partnership interest, indebtedness, inventory and stocks and securities. Properties held primarily for personal use do not qualify as the intent is not for investment but for enjoyment. Vacation properties are eligible for a 1031 exchange. To curb abuse, the IRS released Revenue Procedure 2008-16, effective March 20, 2008, providing a safe harbor that the IRS will not challenge whether the vacation property qualifies as property held for productive use in a trade or investment given the taxpayer meets the test. The safe harbor applies only to the determination of whether the property qualifies as property held for productive use in a trade, business or for investment in addition to satisfying the 1031 exchange requirements.
Safe Harbor Test
The test is that in each of the two years the relinquished or old vacation property is held, the property is rented out at least fourteen overnights at fair market rent. Personal use is not to exceed fourteen overnights or ten percent of the number of days rented per year. Personal use applies to the time friends and family members occupy the property without paying fair market rent. The replacement property must also be held for two years and in each of those two years, the property is rented out at least fourteen overnights at fair market rent. Personal use is not to exceed fourteen overnights or the tent percent rule per year.
1031 Exchange Rules
A series of rules applies to forward, simultaneous and reverse 1031 exchanges. A partial list follows:
Equal to or Greater – To defer one hundred percent of the realized gain, the replacement property must be equal to or greater than the net relinquished sales price. Partial exchanges are acceptable.
Same Taxpayer – The taxpayer who sells is the taxpayer who buys. The exception is if a single member limited liability company owns the relinquished property, then the sole member can acquire the replacement property in their name or vice versa.
Timelines – Forty five calendar days post-closing the replacement property must be identified in a list of up to three or four or more, preferably to the Qualified Intermediary by fax. The 1031 exchange ends on the 180th calendar day post-closing. In a reverse 1031 exchange, the relinquished and replacement properties are identified in the Qualified Exchange Accommodation Agreement.
Qualified Intermediary Use – A Qualified Intermediary (QI) is required to accommodate the 1031 exchange with the exception of a two-party exchange.
Related Party Rules – If selling to a related party, the recognized gain or tax is due if the related party sells within two years of acquiring the relinquished property. The replacement property cannot be acquired from a related party unless the related party is also initiating a 1031 exchange.
Hold Time – The property hold time is not specified in the IRC Section 1031. The IRS acknowledges that two years is sufficient. The Rev Proc 2008-16 provides a safe harbor given specified hold times for vacation property. The suggested hold time is at least one year and a day, though the shorter the hold time the better the fact pattern supporting the 1031 exchange.
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