Should I sell or Exchange?

What qualifies for exchange?

What does not qualify for exchange?

What is the "Boot Test"?

What is a Reverse Exchange?

IRS 1031 facts

Update on vacation homes

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There are many ways to build an estate.
One avenue is through investing in real estate. Careful consideration is given in selecting apartments, land, warehouses, or other types of investment properties. Likewise, the same consideration should be given when moving to another investment property. Unfortunately many do not take advantage of another method left to them: The tax deferred exchange!

The tax-deferred exchange allows the investor to defer paying capital gains tax on their investment properties. Conversely, an investment property that is sold without a tax-deferred exchange can force the seller to pay up to 28% of their gain in taxes! If an investor is looking to purchase other investment properties, then an exchange makes much more sense, because there is now a larger amount of money available to purchase the replacement properties. An investor is able to use the money they would have paid in taxes, and put it to work for them in another investment property.

Any property held for productive use in a trade or business or for investment can be exchanged for like-kind property. "Like kind" refers to the nature of the investment. Any type of investment property can be exchanged for another type of investment property. For example: A single-family rental can be exchanged for a duplex. Raw land can be traded for a shopping center or an office for apartments. Any combination will work. This gives the Exchangor flexibility to change investment strategies to fulfill their needs.

A personal residence, stock in trade (developed lots), property held for resale immediately after acquisition or completion of improvements (speculation homes or fixer type properties that are not rented out or held on for a period of time before being sold), and partnership interests. Second homes may or may not qualify depending on the use and tax.

The "Boot Test" is a device to determine if there is a potential for taxable "boot" in a transaction. It is not a substitute for tax counsel, but it can be a thumb nail analysis to allow one to know if an exchange will be fully or partially tax deferred. The test is done to verify that the Exchangor is moving up and across in value, equity, and mortgage.

The example above is a fully tax deferred exchange. The equity has been moved across into the next property and there is a mortgage of equal or greater value to the mortgage on the Relinquished Property.

In the transaction above there would be some taxable boot. All the equity is not used in acquiring another like-kind property. Whatever the Exchangor put in his pocket would be taxable as boot (in this case it appears to be $50,000).

In the transaction above there would be some taxable boot. A property of lesser value is purchased, and there is a new mortgage of lesser value than the mortgage on the Relinquished Property. The difference between the two mortgages is classified as "mortgage relief," and is taxable as boot (in this transaction it appears to be $25,000). The only way to offset "mortgage relief" in a transaction is to add sufficient cash to offset the difference in mortgages.

Acquisition of the Replacement Property before the Relinquished Property is sold.

Like-Kind exchanges under IRC code Section 1031

Rev. Proc. 2008-16: Safe Harbor for Exchanges of Vacation Homes and Conversions to or from Personal Residences

This revenue procedure 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 under Section 1031. This revenue procedure follows Moore v. Commissioner, T.C. Memo. 2007-134 (the recent vacation home case) and the Treasury Inspector General for Tax Administration (TIGTA) report “Like-Kind Exchanges Require Oversight to Ensure Taxpayer Compliance”(9/17/07), which called for more IRS guidance on vacation home exchanges. The safe harbor, while specifically addressing the vacation home issue, also indirectly addresses the issue of converting a principal residence into qualifying relinquished property prior to an exchange, or converting a replacement property into a personal residence after an exchange.

- It is just a safe harbor. An exchange may still fall outside the parameters and meet the statutory requirements, but you should expect heightened scrutiny in such a case. The safe harbor is effective for exchanges occurring on or after March 10, 2008.

- Relinquished Property. A dwelling unit qualifies as relinquished property in an exchange if it is owned by the taxpayer for at least 24 months immediately before the exchange, and, in each of the two 12-month periods immediately preceding the start of the exchange: (i) The taxpayer rents the relinquished property to another person at a fair rental for 14 days or more, and (ii) the taxpayer's personal use of the relinquished property does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the relinquished property is rented at a fair rental.

- Replacement Property. A dwelling unit qualifies as replacement property in an exchange if it is owned by the taxpayer for at least 24 months immediately after the exchange, and, in each of the two 12-month periods immediately after the exchange: (i) The taxpayer rents the replacement property to another person at a fair rental for 14 days or more, and (ii) The taxpayer's personal use of the replacement property 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. If a taxpayer reports a transaction as an exchange on the taxpayer’s federal return expecting that the replacement property will meet the qualifying use standards, but the replacement property does not meet the qualifying use standards, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange.

- Broad Definition of Personal Use. The taxpayer is deemed to have used a dwelling unit for personal purposes if used by: (A) the taxpayer or any other person who has an interest in such unit (including a tenant in common), or by any member of the family of the taxpayer or such other person; (B) 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 useof such other unit); or (C) by any individual if rented for less than a fair market value rental. A taxpayer may rent the dwelling unit to a family member if the family member uses it as a principal residence (and not a vacation home) and the family member pays fair market rent. Some taxpayer usage may be allowed for repairs and annual maintenance too. See Section 280A(d)(2) and (3). “Fair market rent” is determined based on all of the facts and circumstances that exist when the rental agreement is entered into, and all rights and obligations of the parties to the rental agreement are taken into account. A “dwelling unit” is real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities.

- Comment: How Does the Taxpayer Meet the Safe Harbor for a Vacation Home and Principal Residence? (1) Limit Taxpayer Use. The taxpayer (any any related parties under section 267, other than as a principal residence) can only use the property for 14 days per year (or 10% of the rental period if greater) for the two years prior to the exchange. The taxpayer may use the dwelling some additional days for repairs and annual maintenance too, but be prepared to prove actual work done. (2) Rent It Out. The property also must be rented to unrelated party for at least 14 days per year, but it does not have to be rented more than 14 days per year.(Alternatively, it can be rented as a principal residence to a related party). Therefore, a taxpayer can take a personal residence or vacation home, rent it to a friend for 14 days per year for two years and then exchange out of it, with no question about whether it’s held for investment.All rent must be fair market and the taxpayer should have evidence to prove this. Likewise, the taxpayer can do the same thing on the replacement property for the two years after the exchange (and this must be done if the replacement property is also the taxpayer’s vacation home or future principal residence).