This new 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 for purposes of Section 1031 of the Internal Revenue Code.

Real Estate attorney Scott Alperin says, "The new rule demonstrates a relaxation of the long-standing notion that any real estate used for personal purposes could not also qualify as property held for 'investment' purposes under the tax deferred exchange guidelines. The procedure also provides a specific 'bright line' test for compliance with the safe harbor requirements."

The change reflects a 2007 Tax Court case, Moore v. Commissioner, where the taxpayers exchanged one lakeside vacation home for another. Neither home was ever rented. Both were used by the taxpayers only for personal purposes. The taxpayers claimed that the exchange of the homes was a like-kind exchange under Section 1031 because the properties were expected to appreciate in value and thus were held as investment properties. The Tax Court held, however, that the properties were held for personal use and that the “mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.”

Moore v. Commissioner superceded Starker v. United States (9th Cir. 1979) when the Ninth Circuit held that a personal residence of a taxpayer was not eligible for 1031 exchange, explaining that “[it] has long been the rule that use of property solely as a personal residence is antithetical to its being held for investment.”

The IRS recognizes that many taxpayers hold investment property primarily for the production of current rental income, but also use the properties occasionally for personal purposes. In the interest of sound tax administration, this revenue procedure provides taxpayers with a safe harbor under which a investment property will qualify as property held for productive use in a trade or business or for investment under Section 1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes.

Following is a quick look at the 1031 tax exchange implications
• For the purposes of this revenue procedure, 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.

• The IRS will not challenge whether a dwelling unit as defined in section 3.02 of this revenue procedure qualifies under Section 1031 as property held for productive use in a trade or business or for investment if the qualifying use standards in section 4.02 of this revenue procedure are met for the dwelling unit.

• Qualifying use standards for Relinquished property. A dwelling unit that a taxpayer intends to be relinquished property in a § 1031 exchange qualifies as property held for productive use in a trade or business or for investment if the dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the “qualifying use period”), and, within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange, the taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and the period of the taxpayer’s personal use of the dwelling unit 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. For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).

• Qualify use standards for Replacement property. A dwelling unit that a taxpayer intends to be replacement property in a § 1031 exchange qualifies as property held for productive use in a trade or business or for investment if the dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and, within the qualifying use period, in each of the two 12-month periods immediately after the exchange, the taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and the period of the taxpayer’s personal use of the dwelling unit 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. For this purpose, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.

• Personal use. For purposes of this revenue procedure, personal use of a dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes under Section 280A(d)(2) (taking into account Section 280A(d)(3) but not Section 280A(d)(4)).

• Fair rental. For purposes of this revenue procedure, whether a dwelling unit is rented at a fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the parties to the rental agreement are taken into account.

• Special rule for replacement property. If a taxpayer files a federal income tax return and reports a transaction as an 1031 tax exchange, based on the expectation that a dwelling unit will meet the qualifying use standards in section 4.02(2) of this revenue procedure for replacement property, and subsequently determines that the dwelling unit does not meet the qualifying use standards, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange under Section 1031.

• Limited application of safe harbor. The safe harbor provided in this revenue procedure applies only to the determination of whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under § 1031. A taxpayer utilizing the safe harbor in this revenue procedure also must satisfy all other requirements for a 1031 tax exchange.

Alperin Law specializes in investment property issues and serves a wide range of clients in Virginia, Virginia Beach, Chesapeake, Norfolk, Portsmouth, Suffolk, Hampton, Newport News, and Hampton Roads.