Can I Move into My Vacation Home Without Jeopardizing My Exchange?
Last month we discussed how the global pandemic and remote working have caused people to rethink where they want to live. As part of that trend, clients have been looking at more properties in vacation towns or remote areas with the hope of moving into them at some point. Can they use or move into these properties without jeopardizing their 1031 exchange?
The answer is – it depends.
As a refresher – in order to qualify for tax-deferred treatment under §1031, both the relinquished and replacement properties must be held for investment purposes or for use in the taxpayer’s trade or business. Property held for personal use does not qualify.
How much personal use is too much? Hopefully the properties will appreciate in value as we’re seeing in vacation towns. Is that appreciation sufficient to demonstrate the necessary investment intent? Or does the property have to be rented out to be considered an investment?
The IRS Safe Harbor: Revenue Procedure 2008-16
In 2008 the IRS issued Revenue Procedure 2008-16 to provide some guidance in answering this question. The Revenue Procedure provides a safe harbor which means that if the procedures are followed, the IRS will not challenge whether a property qualifies as being held for productive use in a trade or business or for investment. An exchange may fall outside the safe harbor and still qualify, but expect more scrutiny from the IRS.
In order to fall within the safe harbor, both the relinquished and replacement properties must have been owned by the taxpayer for at least 24 months immediately before and after the exchange. In each of the two 12-month periods immediately before and after the exchange the properties must be rented at a fair market value for 14 days or more. The taxpayer’s personal use cannot exceed the greater of 14 days or 10% of the days during each 12-month period that the property was rented at a fair market value.
“Personal Use” is not limited just to use by the taxpayer. It also includes use by:
- the taxpayer’s family members;
- any other person with an interest in the unit, or their families;
- anyone using the unit under an arrangement which enables the taxpayer to use some other dwelling unit (even if no rent is charged); or
- anyone, if the property is rented for less than fair market value rent.
Meeting the Safe Harbor
In order to fall within the safe harbor, you must meet the ownership requirements mentioned above. You should also limit personal use of the property to the greater of 14 days per year or 10% of the rental period. If you use the property any additional days for repairs and maintenance, be ready to show proof of the actual work done.
The property should be rented to an unrelated party for at least 14 days per year, ideally pursuant a written lease. However, there is no need to rent the property for more than 14 days. You may also rent the property to a related party if they use it as their principal residence and pay fair market value rent.
It is also important to treat the property as an investment. Make sure that the property is properly maintained. Deduct expenses for maintenance, utilities, insurance and depreciation. If you have a mortgage on the property make sure that it is structured as an investment loan, not as a loan for a primary residence.
Once you have owned the property for 24 months, and if you have met the requirements above, you can use the property more frequently or move into it with less concern that you will be jeopardizing your 1031 exchange transaction.
Remember that if you eventually want to sell the property and do another 1031 exchange, the property will have to meet the investment criteria (rental and personal use tests) outlined above for the 24 months prior to the sale in order to fall back within the safe harbor.
A tax-deferred exchange is one of the few wealth building tools available to virtually any investor. Taxpayers should consider the benefits of a tax-deferred exchange whenever they plan to sell property that is not their principal residence.
We, at First American Exchange Company, look forward to working with you on your next exchange.
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