Mixed-use property presents special tax challenge

Q: I am selling a rental house in Albuquerque for a significant profit. The broker on the transaction told me I should consider a Section 1031 exchange to defer taxes. I could acquire a property in Breckenridge to replace it. The issue is that the Breckenridge property would be used in a rental pool and also for vacation use by my family. The broker is unsure whether that is allowed by Section 1031.

A: Section 1031 allows gain deferral when real property held for investment or business use is exchanged for other real property held for investment or business use. The current rental sounds like it will qualify.

Whether replacement property can be treated as held for investment or business use depends on your intent at the time of acquisition. A later change of use will not disqualify the property.

The issue that sometimes arises in Section 1031 is discerning someone’s intent. No one can directly discern your intent so it is common to indirectly discern intent by your actions.

If you buy replacement property and use it for rental only, that action will support an investment intent. If you use it only for personal use, that action will support a personal use intent.

There are tax cases where someone started renting a property and later occupied the property as a principal residence. The outcomes of these cases vary.

The longer the rental use, the more likely the taxpayer is to satisfy Section 1031. If the rental use is for a short duration, people have still succeeded where they had a convincing story that supported a change in intent.

Mixed use presents a special challenge. The tax law has so-called “vacation home” rules that govern the tax treatment of deductions for property used for both investment and personal use.

There is no statutory linkage between the vacation home classification and Section 1031 investment status. Unfortunately, many people assume there is.

Deductions can be limited when personal use of a mixed-use property exceeds the greater of (1) 14 days or (2) 10% of the rental days.

For example, if there are 100 rental days, personal use must exceed 14 days for the limits to apply. If there are 200 rental days, personal use must exceed 20 days.

If personal use is 14 days or less, the deduction limitation does not apply. There still must be sufficient rental use to show your intent is investment use.

Satisfying the vacation home test does not imply investment intent. Conversely, failing the test does not imply no investment intent.

Confused? You should be. A tax adviser would be confused. An IRS agent would be confused. Discerning someone’s intent is simply confusing.

When these confusing situations arise, the IRS sometimes creates a “safe harbor.” This is not the law, because the IRS does not write the law.

It is instead a simple rule that, if followed, will avoid IRS challenge. It can help the taxpayer. It can also help the IRS. Both are confused about the law so both can benefit from the safe harbor.

IRS has a safe harbor for mixed-use property. They say the property will not be challenged as Section 1031 qualified if three tests are satisfied.

First, own the property for at least 24 months. Second, for each of the first 12-month periods after acquisition, do not use the property for personal use more than is allowed by the vacation home rules. Third, rent the house at fair value for at least 14 days in each 12-month period.

The third test is not from the vacation home rules. It is just to show that there is some investment use.

Remember this is a safe harbor so both you and the IRS can avoid senseless bickering. The law still looks at your intent.

IRS is very likely to treat this safe harbor as if it is the law. The IRS guidance itself warns that if you file a return in the first year assuming you will meet the test, and later fail it, you should amend the first-year return.

To be fair, the warning says “if necessary.” If you have the right intent, an amendment is not “necessary,” although IRS would probably disagree.

James R. Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.