Mixed-use ownership presents a particular tax challenge
Q: I am selling a rental home in Albuquerque for a significant profit. The broker in the transaction told me that I should consider a Section 1031 exchange to defer taxes. I could buy property in Breckenridge to replace it. The problem is that the Breckenridge property would be used in a rental pool and also for my family’s vacation. The broker does not know if this is permitted by Section 1031.
A: Section 1031 allows the deferral of gains when real estate held for investment or business use is exchanged for other real estate held for investment or business use. Current rental appears to qualify.
Whether a replacement property qualifies as held for investment or business use depends on your intention at the time of acquisition. A subsequent change of use will not disqualify the property.
The issue that sometimes arises in Section 1031 is discerning someone’s intent. No one can directly discern your intention, so it is common to indirectly discern intention through your actions.
If you are buying a replacement property and using it for rental purposes only, this action will support an investment intent. If you are only using it for personal use, this action will support a personal use intent.
There are tax cases where someone started renting a property and then occupied the property as their primary residence. The results of these cases vary.
The longer the rental use, the more likely the taxpayer is to satisfy Section 1031. If the rental use is short-lived, people have still succeeded where they had a compelling story that supported a change of ownership. intention.
Mixed use presents a particular challenge. The tax law contains so-called “vacation home” rules that govern the tax treatment of deductions for property used for both investment and personal use.
There is no statutory connection between vacation home classification and Section 1031 investment status. Unfortunately, many people assume there is.
Deductions may be limited where personal use of a mixed-use property exceeds the greater of (1) 14 days or (2) 10% of rental days.
For example, if there are 100 rental days, the personal use must exceed 14 days for the limits to apply. If there are 200 rental days, personal use must exceed 20 days.
If the personal use is 14 days or less, the deduction limit does not apply. There must still be sufficient rental use to show that your intent is for investment use.
Satisfying the holiday home criterion does not imply an intention to invest. Conversely, failing the test does not imply the absence of investment intention.
Confused? You should be. A tax advisor would be confused. An IRS agent would be confused. Discerning someone’s intention is simply confusing.
When these confusing situations arise, the taxman sometimes creates a “safe harbor”. It’s not the law, because the IRS doesn’t write the law.
Rather, it is a simple rule that, if followed, will avoid challenge from the IRS. This can help the taxpayer. It can also help the IRS. The two are confused about the law and therefore can both benefit from the safe harbor.
The IRS has a safe harbor for mixed-use property. They say ownership will not be challenged as Section 1031 qualifies if three tests are met.
First, own the property for at least 24 months. Second, for each of the first 12 month periods after acquisition, do not use the property for personal purposes more than permitted by the rules of the vacation home. Third, rent the house at fair value for at least 14 days in any 12 month period.
The third test is not part of the holiday home rules. It’s just to show that there is some use of the investment.
Remember, this is a safe harbor so you and the IRS can avoid senseless bickering. The law always looks at your intention.
The IRS is very likely to treat this safe harbor as if it were the law. The IRS guidelines themselves warn that if you file the first year assuming you will pass the test, and later fail, you must amend the first year return.
To be fair, the disclaimer says “if necessary”. If you have the right intention, an amendment is not “necessary”, although the IRS would probably disagree.
James R. Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected]