Investors contemplating an exchange of properties under I.R.C. §1031 frequently inquire about the length of time a replacement property must be held before one can use the property as a personal residence. Until recently, the IRS has given no clear answer to the question. Now, however, Revenue Procedure 2008-16 offers some guidance not only for properties to be acquired (the replacement property) but also for properties already owned (the relinquished property).

The issue is quite important since the language of the code specifies that only property held for investment or for use in a trade of business may be exchanged for “like-kind” property which is also to be held for investment or for use in a trade or business.

The I.R.S. has long held (Rev. Rul. 59-229, 1959-2 C.B. 180) that a residence is not eligible for an exchange since it is held neither for productive use in a trade or business nor for investment. This position was reconfirmed in 2007 in Moore v . Commissioner when the taxpayers exchanged one lakeside vacation home for another. Neither home was ever rented. Both properties were used by the taxpayers only for personal use. The taxpayers claimed that the properties were eligible since they were expected to appreciate in value and thus were held for investment. The tax court rejected this argument saying that the “mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence . ”

Rev. Proc. 2008-16 is intended by the I.R.S to provide a “safe harbor” under which the Service “will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of §1031of the Internal Revenue Code.” By “safe harbor” the I.R.S means that it will not challenge the eligibility of the property for an exchange if certain conditions are met. The qualifying use standards for both relinquished property and for replacement property are quite similar.

In the case of the Relinquished Property . . .

The property will qualify if:

  1. the dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the qualifying use period), and
  2. within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
    • the taxpayer rents the dwelling unit to another person or persons at a fair market
      rental for 14 days or more, and
    • the period of the taxpayer’s personal use of the dwelling unit does not exceed the
      greater of 14 days or 10 percent of the number of days during the 12-month
      period that the dwelling is rented at a fair rental.

For purposes of defining the 12-month periods, the first period ends on the day before the date of the exchange; the second period ends on the day prior to the beginning of the first 12-month period.

In the case of the Replacement Property…

The rules are the same except that first 12-month period begins on the day following the date on which the exchange takes place, and the second 12-month period begins on the first day after the first 12-month period ends.

In both cases, all the other requirements for a valid §1031 exchange remain intact.

This Rev. Prod. suggests that property must be held as an investment or for trade use for 2 years before and after an exchange. But the Rev. Proc. is a safe harbor and does not necessarily apply to all circumstances. But it does emphasize that those who own an investment property and wish to exchange it for a residential property which they plan later to use as their residence are safer if they rent the acquired property for at least 2 years before occupying it.

Remember, too, that a residential property acquired via an exchange and later converted to a personal residence must be occupied for 2 years and held for a minimum of five (5) years before it will be eligible under §121 for the long-term capital gains exclusion of $500,000 (married, filing jointly) or $250,000 ( singe or married filing separately).

Consult your personal tax attorney or specialist before acting on this information .