Flipped Properties | Mixed-Use Properties | Conversions | Vacation Homes
Some types of investment properties require additional qualification measures, a different type of exchange structure, or extra documentation in order to be used in a Section 1031 exchange.
If any of the following are answered in the affirmative, JELD-WEN 1031 can provide you with additional information needed for a successful Section 1031 exchange transaction:
- Do you live in part of the property you are exchanging?
- Have you agreed to seller financing on the sale of the relinquished property?
- Are you selling to or acquiring property from a relative?
- Do you want to use the exchange proceeds for improvements to the replacement property?
- Must you acquire replacement property before selling the relinquished property (reverse exchange)?
- Is the relinquished property held in a partnership, corporation, limited liability company or living trust?
- Are you receiving cash from the exchange transaction?
- Is the replacement property of lesser value than the relinquished property?
- Is there debt relief?
- Are you acquiring replacement property with a spouse (or others who were not parties to the exchange)?
Flipped Properties
A flipped property is a property that is acquired and immediately sold for a higher price. Whether a flipped property meets tax deferral status in a Section 1031 exchange depends on the intent of the exchanger, according to the IRS. Tax regulations state that property "held primarily for resale" does not qualify for an exchange, (such as when acreage is subdivided into lots and sold; or a property is purchased, fixed-up quickly, and then resold). However, in cases where there was no intent to quickly resell the property and it occurs due to an excellent offer, an exchange may be successful if the exchanger can prove his/her intent was to hold the property for investment. Documentation will be needed to support the intent and reason why the investment property was held for a short time. Maintaining current and accurate records is essential.
Mixed-Use Properties
Mixed-use property is comprised of the principal residence of the exchanger and property that has been held for investment or income purposes. A working ranch that includes a residence or a duplex in which the taxpayer rents one unit and resides in the other unit serves as a good example of mixed-use property.
The value of the investment or income portion of the property qualifies under IRC Section 1031 and the value of the residence may be eligible for gain exclusion under IRC Section 121 which exempts gain of up to $250,000 for a single owner and up to $500,000 for a married couple.
The transaction involving a mixed-use property should be structured as an exchange of the investment portion and as a sale of the principal residence portion. The settlement/escrow agent may elect to prepare separate settlement statements or simply split the sale proceeds according to the respective percentage of value each property is to the transaction with the exchanger receiving cash at closing for the principal residence portion and the exchange proceeds being forwarded to JELD-WEN 1031.
Unique circumstances can add complexity to transactions that qualify under both Sections 121 and 1031. Be sure to consult a tax advisor before considering the sale or exchange of mixed-use property.
Convert Exchange Property to Primary Residence
Since 1997, Code Section 121 allowed a taxpayer to exclude $250,000 ($500,000 if married) of gain when selling a primary residence after having occupied the dwelling for two full years of the preceding five years.
In 2004, IRS added the requirement that property acquired as investment or income property through an IRC Section 1031 exchange and subsequently converted to a primary residence for a minimum of 2 years could be sold by the taxpayer under Section 121 provided the taxpayer owned the property for a full five years.
The Housing Assistance Act of 2008, effective January 1, 2009, further limits the exclusion of gain from the sale of a residence which is allocated to any time of "nonqualified use." Nonqualified use is the time period in which the residence was not used as primary residence. For example, a taxpayer acquires a property through a 1031 exchange in January 2009, and maintains the property as a rental. In January 2012, the taxpayer moves into the property and converts it to primary residence. In January 2015, the taxpayer sells the property. Three of the six years of ownership were nonqualified use for the primary residence exemption. The taxpayer would only be allowed to exclude 3/6 (or 1/2) of the gain from the sale under Section 121.
Code Section 121 allows an exclusion of $250,000 of capital gain for a single taxpayer and $500,000 of capital gain for husband and wife on property that qualifies as the primary residence of the taxpayer for two out of the last five years. Some exceptions may apply. Many investors have been converting their former rental property into their primary residence, living there for two years, selling the property, and excluding the gain. The law now requires that former 1031 exchange property must have been owned for a period of five years before the residential exclusion tax break can apply.
Example A
John and Anne exchanged into a rental house in September 2001. It had been rented for the past three years. In October of 2004 they moved into the house as their primary residence and occupied it for the next two years. In October of 2006 they sold the house. John and Anne would qualify for the exclusion.
Why?
Because the property had been owned for five years.
Example B
Greg and Carol exchanged into a rental house in September of 2002. It had been rented for the past two years. In October of 2004 they moved into the house as their primary residence and occupied it as their primary residence. Now, they have to wait until October 2007 to sell the house if they want to qualify for the exclusion.
Why?
The property has to be owned for a total minimum of five years. The normal 1031 requirements (investment intent at the time of acquisition) still apply and the other primary residence requirements of Code Section 121 apply as well. The law simply creates a situation where you must "hold for five for taxes to dive."
Vacation homes, second homes or recreation property
Exchangers often ask if they can exchange their vacation home, second home or recreation property. In order to qualify for an IRC 1031 tax deferred exchange, the relinquished property and the replacement property must both be held for productive use in a trade or business or for investment purposes.
The intent of the taxpayer at the time of the exchange must be to hold the replacement property as investment property. Applying for and obtaining "owner-occupied" financing defeats a showing of investment intent. Personal use of the replacement property by the taxpayer may also defeat showing investment intent.
Revenue Procedure 2008-16 addresses a "Safe Harbor" for exchanges of vacation homes and conversions to or from personal residences. The revenue procedure is effective for exchanges occurring on or after March 10, 2008 and establishes a safe harbor regarding when a vacation home can be considered investment property for the purposes of an IRC Section 1031 exchange. The ruling states that a vacation home qualifies for an IRC Section 1031 exchange if the investor owns the home for at least 24 months, rents it for at least 14 days for each 12 month period and uses it for personal use no more than the greater of 14 days per year or 10 percent of the number of days during the year that the home is rented. These requirements apply to both the relinquished and replacement properties.
The Housing Assistance Act of 2008, effective January 1, 2009, limits the ability to defer gain on the sale of a vacation home for periods of nonqualified use occurring after January 1, 2009 once the home has been converted to a primary residence.
Taxpayers should consult with their tax or legal advisor to determine if their property will qualify for a tax-deferred exchange.