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Kevin Taylor

Managing the 1031 Exchange Rules for Vacation Homes, Conversions and Mixed Use Properties

It is quite common for clients to call a 1031 exchange company with questions regarding exchanges of their former or future principal residences or vacation homes. After all, if you can have a rental property with some side benefits, it would be the best of two worlds, right? Well, we will discuss the requirements you should be aware of as you evaluate the replacements. So these are the questions imbedded in the 1031 Exchange requirements that must be answered:  Under what circumstances can these dwellings be used as part of a 1031 exchange? Do they satisfy the requirement that both the relinquished and replacement properties must be held for investment or for use in a business or trade? Does some personal use trump the investment use of the property? This article is intended to answer these commonly asked questions: Under what circumstances can a second home or vacation home constitute relinquished or replacement property for the purposes of a 1031 exchange? Can a principal residence be converted into an investment property eligible for 1031 tax deferral upon sale? Can a property that has been held for investment be converted to a principal residence and what are the rules when it is sold? Can a mixed-use property be sold with a personal residence exemption and 1031 exchange deferral? Rules for Including a Vacation Home in a 1031 Exchange Historically, determining whether a home that was both rented out and used by its owner could be eligible for a 1031 tax deferral was difficult to ascertain.  There was some case law but that was a bit inconsistent.  The IRS attempted to provide some definitive guidance regarding some of these questions in the form of Revenue Procedure 2008-16.  As the IRS aptly put it: “The Service recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. In the interest of sound tax administration, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under §1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes.” This revenue procedure made clear that for a relinquished vacation property to qualify for a 1031 exchange, the property has to be owned by the taxpayer and held as an investment for at least 24 months immediately prior to the exchange.  Additionally, within each of the two 12-month periods prior to the sale, the property must have been rented at fair market value to a person for at least 14 days or more, and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented. The requirements for a property to qualify as a 1031 replacement property are very similar.  The property has to be owned by the taxpayer for at least 24 months immediately after the exchange.  Also, within each of the two 12-month periods after the exchange, the property must have been rented at fair market value to a person for at least 14 days or more and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented. The taxpayer is allowed to use the relinquished or replacement property for additional days if the use is for property maintenance or repair. These days and the project and maintenance completed should be documented thoroughly. Rules for Converting a Personal Residence for a 1031 Exchange In many cases, conversion of a personal residence to a property held as an investment or for use in a business or trade “exchange eligible property,” as defined above, may still allow a taxpayer to receive a full exemption of gain pursuant to the rules of Internal Revenue Code (IRC). The comprehensive set of tax laws was created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress and is sometimes also referred to as the Internal Revenue Title. The code is organized according to the topic and covers all relevant rules pertaining to income, gift, estate, sales, payroll, and excise taxes. Internal Revenue Code Section 121 upon sale of the property.  That Code section provides for an exclusion of gain of up to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly upon the sale of a principal residence.  There is a requirement that during the five-year period immediately preceding the sale, the taxpayer must have used the property as a principal residence for a cumulative period of at least two years. Even if the property has had principal residence use followed by exchange eligible use, the taxpayer does not necessarily have to do an exchange on the investment/business use of the property if the total gain can be sheltered by the §121 allowed exclusions.  So even if during the immediate two years preceding the sale, the property was used as exchange eligible property, the taxpayer may still benefit from the personal residence exclusion.  In the event, the gain exceeds the maximums allowed for per IRC Section 121 primary residence, the taxpayer may still be able to shelter the balance via a 1031 exchange, thus combining the benefits of these two code sections. Under Revenue Procedure 2008-16 the conversion of the principal residence to an exchange eligible investment property does not disqualify a family member as the tenant.  However, the revenue procedure requires that this should be done at a fair market rental and it must constitute the family member’s personal residence and not the family member’s vacation home.  There are additional rules for the rental of the property by a family member who co-owns the property with the taxpayer. Should a taxpayer wish to convert the personal residence to exchange eligible property, the

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October 12, 2021 No Comments
Articles
Kevin Taylor

What to know about investments in Multifamily investments

Investing in multifamily properties, which are buildings with multiple residential units, can be a profitable investment opportunity for those looking to enter the real estate market. However, like any investment, it comes with its share of benefits and drawbacks. Benefits of owning Multifamily investment properties: Steady income stream: Multifamily properties can provide a steady income stream through rental income from tenants who occupy the units. Diversification: Investing in multiple residential units provides diversification compared to investing in a single-family home. Scalability: Investors can scale their investments by acquiring additional multifamily properties, increasing their potential for income and growth. Tax benefits: Investors may be able to take advantage of tax deductions and depreciation benefits. Drawbacks of owning Multifamily investment properties: Property management: Managing multifamily properties can be time-consuming and may require additional investment in property management services. Tenant turnover: High tenant turnover can impact occupancy rates and rental income. Maintenance costs: Multifamily properties require ongoing maintenance and repairs, which can be costly. Market conditions: Market conditions, including economic downturns and changes in tenant preferences, can impact the value and potential for rental income. The most lucrative benefit of investing in multifamily properties is the potential for a steady income stream and diversification. The cap rate, or the ratio of net operating income to property value, should be evaluated to ensure a good return on investment. Generally, a higher cap rate indicates a better return on investment, but this can vary depending on the location and condition of the property. There is a moderate level of risk involved in investing in multifamily properties. Property management, tenant turnover, maintenance costs, and market conditions are all factors that can impact the value and potential for rental income. People typically invest in a variety of multifamily properties, including apartment buildings, townhouses, and condominiums. The specific type of multifamily property depends on the investor’s goals and market conditions. Investments in multifamily properties can provide a steady income stream and diversification for investors. However, careful evaluation of the property and market conditions is necessary to minimize risk and maximize returns.

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February 17, 2023 No Comments
Articles
Kevin Taylor

Mastering Reverse 1031 Exchanges: Unlocking Opportunities When Timing Matters Most

Reverse 1031 Exchange Rules Under IRS rules, Internal Revenue Code Section 1031 states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment.” In a typical 1031 Exchange, a taxpayer must sell the old property, known as the Relinquished Property, before acquiring the new property, the Replacement Property. However, due to various circumstances, a taxpayer may risk losing the opportunity to purchase the desired Replacement Property if its closing date comes before the sale of the Relinquished Property. Sometimes, the Relinquished Property might already be under contract. Still, the closing is scheduled after the Replacement Property purchase or the Relinquished Property may not yet be listed or under contract. In such cases, taxpayers can utilize a Reverse Exchange. What is a Reverse Exchange? A “Reverse Exchange” occurs when a taxpayer needs to secure the Replacement Property before the sale of the Relinquished Property. The key to making a Reverse Exchange work is to restructure it so that it no longer appears “reverse” at all. In 2000, the IRS introduced a set of guidelines providing a “safe harbor” for Reverse Exchanges under Rev. Proc. 2000-37. These are commonly known as “parking arrangements,” where either: (i) a property is purchased and “parked” by an exchange accommodation title holder (EAT) for the taxpayer’s benefit until the taxpayer can arrange the sale of the Relinquished Property, or (ii) the taxpayer transfers the Relinquished Property to an EAT, receives the Replacement Property, and later the EAT transfers the Relinquished Property to the buyer. Following these safe harbor rules allows taxpayers to structure a Reverse Exchange in compliance with IRS requirements. Reverse Exchange Process Let’s walk through how a Reverse 1031 Exchange works. Essentially, the IRS has made it easier than it may seem. By utilizing an EAT, a taxpayer can have the Replacement Property “parked” and held on their behalf. They then have up to 180 days to sell the Relinquished Property and complete the exchange. Since the taxpayer does not directly acquire the Replacement Property before the sale of the Relinquished Property, the transaction is executed in the correct sequence as per IRS rules. Though it may seem like a bit of “smoke and mirrors,” the technique is authorized by the IRS. Financing in a Reverse Exchange When considering a Reverse 1031 Exchange, financing is an important aspect. The EAT does not provide the funds to purchase the replacement property. Instead, this can be achieved through a loan from the taxpayer to the EAT, or via a bank loan. The loan is typically paid off once the Relinquished Property sells. During the period when the Replacement Property is held by the EAT, it is leased to the taxpayer, allowing them to sublease it to tenants, collect rent, and manage expenses. Ultimately, the EAT earns a fee for its services, while the taxpayer retains the economic benefits. Cost of a Reverse Exchange The cost of a Reverse 1031 Exchange varies based on several factors, including property type (residential, commercial, industrial), property value, and the source of financing (taxpayer-funded or bank-financed). Additional considerations, such as environmental issues, may also impact costs. Since the exchange company holds the title, these variables play a role in determining the overall expense. Relationship of Reverse Exchange and Forward Exchange There is often confusion between Reverse Exchanges and Forward Exchanges. Taxpayers may ask, “Why do I need a Forward Exchange if I’m doing (and paying for) a Reverse Exchange?” Although they relate to a single transaction, they are separate but essential parts. The Reverse Exchange allows the Replacement Property to be secured, preserving the taxpayer’s ability to exchange for it. Technically, a Reverse Exchange is not a 1031 Exchange but rather a mechanism to facilitate one. The Forward Exchange is the actual 1031 Exchange, where the Relinquished Property is sold and replaced. Both processes are necessary to complete a successful Reverse Exchange. The Forward Exchange is handled by a Qualified Intermediary under a different set of IRS rules than those governing an EAT providing Reverse Exchange services. It is possible to use a single company, like InSight 1031, to act as both the EAT and the Qualified Intermediary, or separate companies specializing in one type of exchange service. The content in this blog is intended for informational purposes only. It is not to be construed as investment, legal, tax, or compliance advice. InSight 1031 operates as a Qualified Intermediary, facilitating tax-deferred exchanges under Section 1031 and does not provide investment, legal, or tax advisory services.

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April 21, 2022 No Comments

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