Maintenance, personal and related party use issues surface when owning an investment property either acquired in or when owning a relinquished property with the intent to initiate a 1031 exchange when selling. Proper 1031 intent is to hold the real property, in the productive use of a business or for investment versus holding primarily for personal use. Facts support the investment intent such as how the property is reported on the taxpayer’s federal tax return, was the property in a rental pool and whether personal use exceeds the 14 overnights or ten percent of the rental days per year for real property.
1031 Exchange
An Internal Revenue Code (IRC) Section 1031 tax deferred exchange allows the taxpayer to defer the federal, state capital gain and recaptured depreciation taxes triggered when selling property held primarily in a business or for investment when replaced with property of equal or greater value held in a business or for investment. The tax deferral has many rules, such as the same taxpayer requirement, 45 and 180 calendar day timeframes and g(6) limitations of the code, requiring a qualified intermediary to hold the exchange funds in a manner such that the taxpayer does not receive, pledge, borrow or otherwise obtain the benefits of the exchange proceeds other than towards the purchase of replacement property. If exchange funds remain post completion of the 1031 exchange, the funds are conveyed to the taxpayer and taxed accordingly.
Personal Use
In Revenue Procedure 2008-16, applicable for exchanges on or after March 10, 2008, the Internal Revenue Service (IRS) provides a safe harbor test for vacation properties and second homes that should the taxpayer satisfy, the IRS will not challenge whether the vacation home qualifies as property held for productive use or investment. If outside of the safe harbor test, the taxpayer should be prepared to decisively substantiate that profit is the primary motive for owning the vacation property.
IRC Section 280A(d)(2), the IRS qualifies personal use as when a dwelling unit (real property defined as a house, apartment, condominium or improvements that include living accommodations such as cooking, sleeping and bathroom facilities) is used principally for personal purposes. The code further stated that the taxpayer has used the property if it is used by (i) the taxpayer or any other person who has an interest in such unit, or, by any member of the family of the taxpayer or such other person; (ii) by any individual who uses the unit under an arrangement which enables the taxpayer to use some other dwelling unit (whether or not a rental is charged for the use of such other unit); or (iii) by any individual, unless it is rented for fair rent, as determined by the facts and circumstances.
Related party use is considered to be taxpayer personal use. A related party includes the taxpayer’s family, such as brothers and sisters independent whether whole or by half blood, spouse, parents and lineal descendants, but not aunts and uncles, nephews and nieces, in-laws, stepparents or domestic partners. The exception is that a related party can rent property as their principal residence per Section 280A(d)(3) at fair market value. Consequently, a taxpayer’s child or family member can rent as their primary residence, but not as a vacation property without impacting the taxpayer’s personal use even at fair market value.
Maintenance
Though regulations have not been issued for maintenance, Section 280A(d)(2) provides that the Secretary of Treasury will establish regulations for use of unit for repairs and annual maintenance. Should the taxpayer be employed to provide repair and maintenance for the entirety of any day, the IRS will not treat as being used for personal use by the taxpayer independent if the property is rented.
Exchanges are recognized by the IRS as an approved strategy to defer capital gain tax. If you are considering the sale and replacement of property and have questions regarding how your tax deferred exchange would work, contact our office or click on the button above to ask a question or being your consultation.
