Real Property Law

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Issues Relating to "Held for Investment" Under IRC Section 1031
Mary Kay Kennedy, Vice President and Counsel, First American Exchange Company, LLC, San Jose
E-mail: mkkennedy@firstam.com

Introduction
Personal Residence
Vacation Homes
Held for Sale
Mixed Use Properties
Converting to or from Personal Use
New Five-Year Holding Period
Computing Gain Under IRC Section 121 and 1031


Introduction
Under Section 1031 of the Internal Revenue Code, real estate owners and investors can dispose of property held for investment or for use in the investor’s trade or business and use the proceeds to acquire new property. If structured as an exchange under Section 1031, the tax payable on any gain from the sale of the property is deferred until the new property is sold and the investor is able to use all of the funds to invest in new property rather than using a portion to pay the tax. Both the property disposed of (the "relinquished property") and the property acquired (the "replacement property") must be either held for investment purposes or for use in the investor’s trade or business.

Personal Residence
Because of the "held for investment" requirement, a taxpayer’s personal residence does not qualify for deferral of gain under Section 1031, although it may qualify for exclusion of gain under Internal Revenue Code Section 121. Under IRC Section 121, a taxpayer may exclude up to $250,000 of gain ($500,000 for married taxpayers filing jointly) from the sale of a home if the taxpayer used it as a personal residence for at least two years of the preceding five year period. This exclusion is only available once every two years.

Vacation Homes
There is no clear test for determining when a vacation home is a personal residence or when it is held for investment. However, many tax advisors look for guidance to IRC Section 280A, which specifies when a taxpayer may claim losses on a second home. Under Section 280A, if a taxpayer uses the property in any one year more than the greater of 14 days or 10% of the number of days it was rented for fair market value, losses cannot be deducted for that property. Many tax advisors recommend that, to establish that the property is investment property, a taxpayer should at a minimum comply with the Section 280A requirements regarding the deduction of losses, but also go beyond them by treating the property as investment property to the greatest extent possible. For example, keeping records for the property that are separate from the taxpayer’s records for his personal residence may help establish the intent to hold the property as investment property rather than for personal use.

Held for Sale
There is a specific exclusion from the benefits of Section 1031 for property that is "stock in trade" or "held primarily for sale." (See IRC Section 1031(a)(1).) Accordingly, property that is held primarily for sale, whether to customers in the ordinary course of business or otherwise, is not property that is held for investment. For example, a taxpayer who buys land, subdivides it and sells off the lots, may be considered a dealer who holds the property primarily for sale rather than for investment, and therefore would not be able to defer the gain from the sale under Section 1031.

Mixed Use Properties
Investors may own property both as a personal residence and for business or investment-related use. For example, an investor may own a duplex, live in one unit and rent the other unit. Upon the sale of the duplex, the investor can structure it as a sale of his personal residence as to one-half of the property, and as an exchange of the other half under Section 1031. It is also common for taxpayers to use a portion of their home as an office. In such cases, a taxpayer can take advantage of both the exclusion of gain for a personal residence under Section 121, and a deferral of gain for investment property under Section 1031. New rules concerning these mixed use properties are discussed below.

Converting to or from Personal Use
Sometimes investors will use a property for their personal residence and then move out and rent it, thus converting it to investment property. Although it is possible to convert property from personal use to business use and vice versa (see Revenue Ruling 57-244), it is unclear how long it takes for the conversion to take effect. In other words, how long must an investor rent property before the investor can claim that it is not a personal residence but rather investment property that may be traded under IRC Section 1031? Many tax advisors recommend that investors rent property for at least one year to establish it as investment property before initiating an exchange. This results in the taxpayer filing one or two tax returns that list the property as investment property. Although there is no statutorily required period, the longer the holding period, the easier it is to establish that the investor intended to hold the property for investment rather than for personal use.

New Five-Year Holding Period
There are two recent developments that affect investors who use property both for personal use and for investment. The first development closed a loophole for taxpayers who acquire property in an exchange, convert it to personal use, live in it for two years and then sell it and exclude up to $250,000 of gain on the sale under IRC Section 121. In late 2004, IRC Section 121 was revised to add a five year holding period before a taxpayer can exclude gain under Section 121 when selling a personal residence that was acquired initially as investment property in an exchange. In other words, if a taxpayer acquires investment property in a Section 1031 exchange, rents it for two years, and then moves in and uses it as a personal residence for two years, he cannot exclude gain upon the sale of that property because he has not held it for a total of five years (even though he has met the requirement of living in it for two of the past five years). On the other hand, if he rents it for three years and lives in it for two, he will be able to sell it and exclude up to $250,000 of the gain pursuant to IRC Section 121, since he has owned it for a total of at least five years and lived in it at least two of those five years.

Computing Gain Under IRC Section 121 and 1031
On January 27, 2005, the IRS issued Revenue Procedure 2005-14, which explains how to apply IRC Sections 121 and 1031 to a single property. This is relevant when an investor acquires property for investment purposes and eventually converts it to personal use or vice versa. It also applies when one property is used concurrently for two purposes, such as a house containing a home office.

The Revenue Procedure accomplishes several things. It confirms that upon the sale of property that has been used for investment or business purposes and as a personal residence, both IRC Sections 121 and 1031 can be used to exclude and defer gain on the same property. The Revenue Procedure states that, when computing the gain, Section 121 should be applied prior to applying Section 1031. Moreover, gain attributable to depreciation cannot be excluded under Section 121, but can be deferred under Section 1031 for these mixed use properties. The ruling includes an explanation of how to compute the basis of the new property when trading out of mixed use property into mixed use or investment property. Finally, the Revenue Procedure goes through six different examples to clarify how the new rules are to be applied in situations where the relinquished and replacement properties are mixed use property.

 

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