IRS Creates Safe Harbor for 1031 Property With Limited Personal Use

On February 21, 2008 the IRS issued Revenue Procedure 2008-16 clarifying that limited personal use won’t prevent a rental property from qualifying as property held for trade or business or investment use for purposes of the section 1031 tax-free exchange rules.

Section 1031 allows no gain or loss to be recognized on the exchange of property held for productive use in a trade or business, or for investment if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment. A common example is exchanging rental real estate for other rental real estate.
The IRS has provided taxpayers with a safe harbor for which dwelling units (houses, apartments, condominiums, or similar improvement that provides basic living accommodations) will qualify as property eligible for a 1031 exchange. The new safe harbor applies when:

• The taxpayer must own the relinquished property at least 24 months immediately before the exchange;
• The taxpayer must own the replacement property for at least 24 months immediately after the exchange;
• The relinquished property must be rented at fair rental value for 14 days or more for the two 12-month periods immediately preceding the exchange; and
• Personal use by the taxpayer doesn’t exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at fair rental value.

For example, John sells rental real estate on April 1, 2008. For the 24 months prior to April 1 (April 1, 2006 – March 31, 2008) the property was rented for more than 14 days in each of the two 12-month periods and his personal use didn’t exceed the limits stated above. The exchange for the replacement property is completed on September 1, 2008. John must rent the property for 14 days or more for the 24-month period beginning on September 1, 2008 (September 1, 2008 – August 31, 2010) and limit his personal use. If he fails the personal use test during the 24 months, an amended tax return for 2008 must be filed as the transaction won’t qualify for 1031 treatment.

Personal use does not include days used as a principal residence. The procedure is clear, use as a principal residence would breach the 24-month safe harbor. The IRS has stressed that the new safe harbor applies only to the determination of whether a dwelling unit is held for productive use in a trade or business or for investment under code section 1031, and that a taxpayer using the safe harbor also must satisfy all other requirements for a like-kind exchange under code section 1031.

Revenue Procedure 2008-16 is effective for exchanges occurring after March 9, 2008.

For additional information, please contact Tax Partner Peter Pfister at The Curchin Group at 732.747.0500, or at ppfister@curchin.com.