One of the singularly most powerful parts of tax planning is property use conversion. Changes in circumstances may cause a personal residence to become a rental property or a rental property to become a personal residence. In the determination of whether real property qualifies as either a personal residence or qualifying property under Section 1031 the intent and tax treatment is of absolute and primary importance.
Internal Revenue Code section 1031 allows clients to legally defer taxes on the capital gains generated by the sale of property when property is exchanged for other like-kind property. The qualifications are complicated but the taxpayer's intent to use the property as an investment is a key component. A change in the purpose of an acquisition may impact the IRS acceptance of the tax deferred exchange for the exclusion of capital gains tax.
For example, an investor plans to exchange a residential property currently used as income producing for a larger home. They fully intend to move into the home within a short time. Their plan is to exchange for the higher priced home using Section 1031, then rent to tenants for a short time, thereby establishing the future primary residence as qualifying property under Section 1031 until they move into the residence. The basic flaw: their intent is to live in the property as a personal residence. Income generated from its revenue is hardly enough to defend a position of use as income property. It is likely the exchange would be challenged.
The question remains; How long does the investor need to rent the new home out before they can convert its usage to their primary residence without fearing the IRS would challenge their I.R.C. §1031 exchange?
Many taxpayers have made exchanges into rental properties and then converted the property to a personal residence, planning to resell after living on the property for two years and take advantage of the $250,000 or $500,000 capital gains exclusion. Sometimes the taxpayer had done this within three or four years of the exchange.
Pursuant to the American Jobs Creation Act (signed by President Bush on October 22, 2004), a property acquired in a 1031 exchange and later converted to a principal residence must be owned for five years from the date of the exchange before the owner can sell the residence and claim the capital gains exclusion.
So, in order to take advantage of a 1031 exchange and the capital gains exclusion, the owner must have both used it as a principal residence for two years and owned it for five years.
1. The primary purpose for which property was originally acquired, does not necessarily determine the tax consequence at the date of its subsequent exchange or even sale. Revenue Ruling 57-244 shows acquisition purpose can change. The IRS considered the circumstances of three taxpayers who purchased property for the construction of homes and later abandoned that purpose for clearly established reasons. The taxpayers continued to hold the property for investment purposes. A subsequent exchange was held to qualify under !.R.C. §1031.
Investors should consult their own tax advisor on this important decision.
2. 45 Day Identification Requirement
How Does It Work?
An Exchangor must follow certain IRS guidelines to remain within the 'safe harbor' regulations.
The replacement property in an exchange must be identified on or before the 45th day after the date the taxpayer transfers the relinquished property in the exchange. The replacement property must be purchased by the 180th day after the date the taxpayer transfers the relinquished property.
0---------------45 ----------- 180
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