IRS Provides Sec. 1031 Personal Use Safe Harbor for Dwellings

By Alistair M. Nevius, J.D.

The IRS has provided a safe harbor, under which it will not challenge whether a dwelling unit qualifies as held for productive use in a trade or business or for investment purposes under Sec. 1031, governing like-kind exchanges (Rev. Proc. 2008-16).

Under Sec. 1031, taxpayers may exchange property held for productive use in a trade or business or for investment for property of like kind and not recognize any gain or loss from the exchange. The Service has previously ruled that principal residences are not eligible for this treatment because they do not qualify as property held for productive use in a trade or business or for investment (Rev. Rul. 59-229; Rev. Proc. 2005-14).

This has created a dilemma for taxpayers who own properties that they hold primarily as rental properties but that they occasionally use for personal purposes. How much personal use disqualifies a property for Sec. 1031 purposes?

The IRS has now created a safe harbor to provide guidance on this issue. Under the terms of Rev. Proc. 2008-16, the Service will not challenge whether a dwelling unit was held for productive use in a trade or business or for investment for Sec. 1031 purposes if the following conditions are met:

1. The relinquished dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange.

2. In each of the two 12-month periods that make up that 24-month period under condition (1), the taxpayer rents the dwelling unit to another person at a fair rental for at least 14 days and the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10% of the number of days that the dwelling unit was rented.

A similar safe harbor applies to the replacement property acquired in the exchange (but applicable to the 24 months immediately after the exchange).

The safe harbor 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 for purposes of Sec. 1031. A taxpayer that meets the safe-harbor requirements must also meet all other requirements for a like-kind exchange.

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