IRS Provides Safe Harbor for “Dwelling Units” Exchanged as Part of Section 1031 (Like-Kind) Exchange

By: Jeffrey "Jeff" Rubinger, Holland + Knight

In a taxpayer-friendly ruling (Revenue Procedure 2008-16) (the Ruling), the IRS provides a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies as property “held for productive use in a trade or business or for investment” for purposes of applying the like-kind exchange rules of Section 1031 of the Internal Revenue Code (the Code). For this purpose, a dwelling unit is defined as “real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities.” The issuance of this safe harbor represents a significant departure from the position historically taken by the IRS on this issue and likely will lead to an increased use of the Section 1031 provisions by taxpayers holding dwelling units that have significantly appreciated in value.

Historical Treatment of Dwelling Units Under Section 1031

In general, Section 1031(a) of the Code provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment (i.e., the relinquished property) if such 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 (i.e., the replacement property).

Historically, the IRS has taken the position that gain or loss from an exchange of a personal residence could not be deferred under Section 1031 because a residence is generally not property held for productive use in a trade or business or for investment. See Rev. Rul. 59-223, 1959-2 C.B. 180.

A number of courts have agreed with the IRS in this regard. For example, in Moore v. Commissioner, the taxpayers exchanged one lakeside vacation home for another. Neither home was ever rented. Both were used by the taxpayers only for personal purposes. The taxpayers claimed that the exchange of the homes was a like-kind exchange under Section 1031 because the properties were expected to appreciate in value and thus were “held for investment.” The Tax Court specifically rejected this argument, holding that the properties were held for personal use and that the “mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.”

Similarly, in Starker v. United States, the Ninth Circuit Court of Appeals held that a personal residence of a taxpayer was not eligible for exchange under Section 1031, explaining that “[it] has long been the rule that use of property solely as a personal residence is antithetical to its being held for investment.”

New Safe Harbor

Recognizing that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes, the IRS felt it was “[i]n the interest of sound tax administration” to provide a safe harbor with respect to this issue. Under the Ruling, the IRS indicates that it will not challenge whether a dwelling unit qualifies under Section 1031 as property held for productive use in a trade or business or for investment if certain factors are satisfied.

With respect to relinquished property, the IRS will not challenge whether the dwelling unit is eligible for Section 1031 exchange treatment if:

(1)The dwelling unit is owned by the taxpayer for at least 24 mosnths immediately before the exchange (the “qualifying use period”); and
(2)Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,

(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and

(ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental

Similarly, with respect to replacement property, the IRS will not challenge whether a dwelling unit is eligible for Section 1031 exchange treatment if:

(1) The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and

(2) Within the qualifying use period, in each of the two 12-month periods immediately after the exchange,

(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and

(ii)The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12- month period that the dwelling unit is rented at a fair rental.

Limitations of Ruling

Two important points should be qualified under this Ruling. First, if a taxpayer files a federal income tax return reporting a transaction as an exchange under Section 1031, based on the expectation that a dwelling unit intended as replacement property will satisfy the qualifying use standards set forth in the Ruling, and subsequently determines that the dwelling unit intended as replacement property does not satisfy these standards, the taxpayer, if necessary, is required to file an amended return and not report the transaction as an exchange eligible for like-kind exchange treatment under Section 1031.

Second, the IRS makes it clear that the safe harbor set forth in the Ruling is limited to the determination of whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031. Therefore, a taxpayer relying on the safe harbor also must satisfy all other requirements for a like-kind exchange set forth under Section 1031 and the regulations thereunder.

Effective Date

The safe harbor is intended to be effective for exchanges of dwelling units occurring on or after March 10, 2008. The IRS reiterates, however, that “[n]o inference is intended with respect to the federal income tax treatment of exchanges of dwelling units occurring prior to the effective date” of the Ruling.

For more information, email Jeffrey L. Rubinger at jeffrey.rubinger@hklaw.com or call toll free, 1.888.688.8500.