REXN SECOND HOMES IN EXCHANGING

An issue that we see frequently is the potential for applying Section 1031 to second homes. One of the fundamental requirements of Section 1031 is that the exchanged properties must be "held for productive use in a trade or business or for investment." As a result, residences used for personal use cannot qualify under Section 1031. However, owners of second homes that are patient and that are willing to make a bona fide conversion of the second home or the primary residence into rental property may be handsomely rewarded under Section 1031.

1. "Conversion" of a second home.

Jane Smith has been a successful Massachusetts real-estate broker for many years. For those many years she happily has been married to a CPA and they have enjoyed economic prosperity. (As a statistical matter, members of the accounting profession are the least likely among us to become divorced.) In addition to their home in Westwood, Massachusetts, the couple owns a second home in Falmouth on Cape Cod.

That home, purchased many years ago, is now worth $300,000 with a basis of $30,000. The Smiths expect to retire within the next three to six years, and may well move to a warmer climate such as Florida or Arizona. If the Falmouth property were sold today, the resulting gain of $270,000 would attract a twenty percent federal capital gains tax and a Massachusetts capital gains tax of two percent. In contrast, if the Smiths could exchange their Falmouth property for property located in Phoenix or Miami, with that property being acquired for rental purposes, then no gain would be due on the exchange assuming all of the relevant requirements of Section 1031 could be met.

In order to make the Falmouth property eligible to be disposed in a Section 1031 exchange, the first thing that

must happen is that there be a bona fide "conversion" of the Falmouth property. The property must become rental property and not personal use or vacation home property. What this means is that the Smiths must now lease out the Falmouth property, preferably on a year-round basis. Personal use of the property should be kept to a minimum and in no event should it exceed the limitations allowed by Section 280A – the personal use should be no more than the greater of fourteen days or ten percent of the number of days that the property is rented.

2. Getting from here to there: time, time, time is on your side.

Once the conversion is complete, the Falmouth property may be exchanged for the replacement property in Florida, Arizona or anywhere else in the United States. That replacement property also must be held for bona fide rental or investment purposes over a period of time in order for Section 1031 to apply. Following are some of the points and pitfalls for the Smiths to keep in mind.

Facts and circumstances. Whether the Falmouth property has become rental property will depend on a review of the facts and circumstances. Was the property continually rented or offered for rent? Was the Smiths’ use limited to visits for maintenance and upkeep or personal use not exceeding the Section 280A limits? Did the Smiths attempt to claim homestead status or personal use property tax exemptions with respect to the property? Did the Smiths realize a profit and/or was the rental charged and conditions of the lease a reflection of arms-length bargaining consistent with the market?

DISCLAIMER

AEC Quarterly is intended to provide basic information with respect to Section 1031 exchanges. AEC encourages all to seek tax and/or legal counsel with regard to their circumstances.

Time. One of the most significant facts is the length of time the Falmouth property is rented and/or offered for rent. It seems difficult for the IRS to argue that a conversion has not occurred if the Falmouth home is rented for a period of at least two years prior to the exchange.

And time again. Similarly, a rental of the replacement property for at least two years would also seem to satisfy the requirement that property be held for "use in a trade or business or for investment." For example in LTR 8310016, the taxpayer planned to exchange a rental property (beach house) for a residence. The residence was then to be immediately offered for sale. The IRS ruled that the exchange did not qualify under Section 1031 because the replacement property (the residence) would not be held for rental. However, the taxpayer then resubmitted its ruling request indicating that it would hold the replacement property for rental "for a minimum of two years." The Service ruled that the exchange would qualify under Section 1031.

3. Four years? – that’s a long time.

Four years is a long time. However, the four-year time frame is the standard plain vanilla approach. If the facts support the analysis, shorter time frames may be in order. For example, in Wagnesen v. Commissioner, 74 T.C. 653 (1980) the taxpayer completed an exchange, and nine months thereafter he transferred the replacement property to his son as a gift. The court held that the exchange qualified because at the time of the exchange, the intent was to hold the property for rental purposes and the intent to make the gift was formed thereafter. A similar shortened time frame on the period for renting the relinquished property may arise where, for example, an unsolicited offer to buy is received by the taxpayer.