Q: We own a condominium that we rent seasonally. My wife and I visit the property to check up on it and take mini vacations three or four times a year. We want to sell the property as part of a like kind exchange. Will our personal use disqualify the property for like kind exchange purposes?
A: A like kind exchange is a transaction or series of transactions in which a taxpayer “trades” one property for another. The transaction can be structured so that the taxpayer sells one property with funds deposited within an intermediary. The intermediary later uses those funds to acquire a replacement property in name of the taxpayer. If properly structured, the taxpayer can defer paying taxes on any gain from sale of the first property until sale of the second property (or even later if another like kind exchange is used).
To qualify for like kind exchange treatment, the property must be held for productive use in a trade or business or for investment and must be exchanged for the same kind of property held for productive use in a trade or business or for investment.
The business or investment requirement has generally disqualified personal residences, including vacation homes. In Starker v. United States, the 9th Circuit Court of Appeals held that a personal residence was not eligible for like kind exchange because the residence was not held for investment purposes.
In 2007, the Tax Court disqualified trade of vacation homes from like kind exchange treatment because neither home was ever rented. Although the taxpayer argued that the properties had been purchased with the intent that they appreciate in value, the Court held that mere hope or expectation that property may be sold does not establish investment intent if the owner uses the property as a residence.
These cases left open a gray area where the property was used for both rental and personal use. Earlier this year, the IRS addressed this issue in Revenue Procedure 2008-16. The Revenue Procedure provides a safe harbor for exchanges involving dwelling units, which are 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.
Under the revenue procedure, a dwelling unit will qualify for like kind exchange treatment if (1) the property is owned by the taxpayer for at least twenty-four months immediately before the exchange (qualifying use person); (2) within the qualifier use period in each of the two twelve month periods immediately preceding the exchange; (a) the taxpayer rents the dwelling unit to another person or persons for a fair rental for fourteen days or more; and (b) the period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of fourteen days or ten percent of the number of days during the twelve month period the dwelling unit is rented at a fair rental.
A dwelling unit that a taxpayer receives as replacement property will qualify if (1) the dwelling unit is owned by the taxpayer for at least twenty-four (24) months immediately after the exchange (the qualifying use period); and (2) within the qualifying use period, in each of the two twelve month periods immediately after the exchange (a) the taxpayer rents the dwelling unit to another person or persons at a fair rental for fourteen (14) days or more and (b) the period of the taxpayers personal use does not exceed the greater of fourteen (14) days or 10 percent of the number of days during the twelve (12) month period the dwelling unit is rented.
For purposes of the Revenue Procedure, personal use of the dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes. A fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered.
The safe harbor is effective for all exchanges on and after March 10, 2008.
The safe harbor offers taxpayers a guaranty of compliance. Although other transactions may also qualify or ultimately be held to qualify by the Courts, failure to qualify the safe harbor places you at some risk.
As with all legal matters, I suggest you discuss the specific circumstances of your case with a qualified attorney or, the tax area, a qualified CPA.
William G. Morris is a lawyer with offices at 247 N. Collier Blvd., Marco Island. The column is not intended to be legal advice for specific circumstances. General questions can be sent by e-mail to firstname.lastname@example.org or by fax to (239) 642-0722. Read other columns at http://www.wgmorris.com.