This article is intended for educational purposes only and not as legal nor tax advice
December 28, 2015
Rev. Proc. 2008-16 creates a “safe harbor” for 1031 exchanges of vacation property.; Under Rev. Proc. 2008-16, a “dwelling unit” is defined as any real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations, which include a sleeping space, bathroom and cooking facilities. The IRS has 2 requirements: (1) the relinquished dwelling unit is owned by the property owner for at least 24 months immediately prior to the exchange. The same goes for the replacement property, and this is referred to as the “qualifying use period”; and (2) within each of the two 12-month periods which make up the qualifying use period (whether for the relinquished property or the replacement property): (a) the property owner rents the property to another person or persons at a fair rental for 14 or more days; and (b) the property owner’s personal use of the dwelling unit does not exceed the greater of: 14 days, or 10% of the number of days the dwelling is rented out.
A clever technique utilized by taxpayers is to convert residential investment property, when suitable, into their primary residence for the requisite period of time and then take advantage of IRC Section 121. The property must be the taxpayer’s primary residence, and the taxpayer must have owned and lived in the home 2 of the last 5 years. If these criteria are met, a single taxpayer may exclude $250,000 of their gain and certain married taxpayers may exclude $500,000. A taxpayer can claim the full exclusion once every two years. A reduced exclusion is available to anyone who does not meet these requirements because of a change in place of employment, health or certain unforeseen circumstances. The gain on the sale of a house is now permanently excluded, rather than deferred, and a taxpayer doesn’t have to purchase a replacement home to exclude the gain. Rather, they may want to do so and stay at least 2 or more years so they can hopefully realize another non-taxable gain.
To conclude, here is a simple summary of the steps to complete a typical 1031 real property exchange:
1. Retain Qualified Intermediary (QI). Be careful – see Part 1.
2. The Exchangor enters into a contract to sell the property to be relinquished and discloses the Exchangor’s intent to enter into a 1031 exchange in the sales agreement. That clearly establishes notice to all parties of the Exchangor’s intent to enter into an exchange right from the beginning.
3. The QI prepares documents and provides the closing agent with instructions.
4. Closing takes place and the proceeds are forwarded to the QI. See my advice in Part 1 regarding protecting such funds.
5. The Exchangor identifies the possible replacement property or properties within the 45-Day Identification Period to the QI in writing.
6. The Exchangor enters into a contract to purchase the replacement property or properties and discloses the Exchangor’s intent to complete the second leg of their 1031 Exchange in the contract again documenting all parties were made aware of the exchange.
7. The QI coordinates the second leg of the exchange with the closing agent of the replacement property; transfers the funds; and completes the purchase of the replacement property within 180 days.