Is it okay to use replacement property for personal use?
“Can I exchange into a property and use it for personal use?” We frequently field this question from investment property owners, especially those who have owned investment real estate for years and are exploring ways to reap the benefits of their hard work.
Fortunately, the IRS provides guidance that specifically addresses the question of tax-deferred 1031 Exchanges into personal use property. Section 1031 of the Internal Revenue Code states “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”¹
“Like kind” refers to any type of real property such as residential rental property, commercial office, agricultural, etc. as long as it is used for business or held for investment purposes. The definition is the crux of the issue – is it possible to perform an exchange from a property held for business or investment purposes into a property that is, at least in part, used for personal purposes, without breaching the like-kind requirement? For example, would it be possible to sell an apartment building and exchange into a vacation condo in Hawaii that is both rented and used personally?
The answer is YES, this is in fact possible, however the rules outlined in Revenue Procedure 2008-16 must be followed in order to qualify.
IRS Revenue Procedure 2008-16
If the rules below are adhered to, IRS Revenue Procedure 2008-16 explicitly provides a safe harbor and the IRS will not challenge whether the property qualifies as being held for productive use.
- If: The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”)
- And: Within the qualifying use period, in each of the two 12-month periods immediately after the exchange, the taxpayer rents the dwelling unit to another person or persons at a fair 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 unit is rented at a fair rental.
In layman’s terms, this boils down to three key points:
- Hold the replacement property for at least two years
- Rent the property at fair market value for 14 days or more, for each of the two years
- Personal use should not exceed the greater of either 14 days per year or 10% of total days rented out for the year
Example 1: If a beachfront property in Hawaii is rented out for 30 days of the year following its acquisition via a 1031 exchange, the owner may use the property for personal purposes a maximum of 14 days that year.
Example 2: If the same beachfront property is rented out for 250 days, the owner may then use the property for a maximum of 25 days, which is 10% of the total days rented out.
After 24 months, can the owner decide that they would like to exclusively use a replacement property for personal use? The IRS does not speak directly to this question however, because the safe harbor includes a defined period of time in which the replacement property must have rental income, it is safe to assume that any use of the property following the 24 month period is permissible. While the intent of an exchange is to hold property for business use or as an investment, an owner’s situation does change over time. The IRS understands this and does allow for reclassification of properties from investment property to personal use, and vice-versa, provided sufficient hold-periods are adhered to. It is commonly recommended that owners report rental income on at least two tax returns before converting a property to solely personal use. Additionally, documenting the property was rented at market rates is a best practice, especially if the property is to be rented to friends or family.
Lastly, should a replacement property be converted to not only personal use but also a primary residence, it pays to take note of the Internal Revenue Code section 121 exclusion, which allows taxpayers to exclude up to $250,000 ($500,000 if married) of gains on the sale of a property used as a primary residence for two of the five years leading up to the sale. For more information on 1031 Exchanges and primary residence real estate, see our article entitled “Tax Strategy for your Highly Appreciated Primary Residence.”
As every investor situation is unique, one should always consult with their tax preparer to ensure compliance with all rules and regulations.
Find Out if a 1031 Exchange is Right for You.
If you are considering selling your investment property and would like to find out if a tax-deferred 1031 Exchange is right for you, we invite you to take advantage of our Complimentary 1031 Consultation to discuss your investment property, objectives, potential tax liability, and tax-deferral options.
Our free consultations can be done over the phone, via web meeting, or in person at our office in Mercer Island, Washington, or in Portland, Oregon. To schedule your free consultation, call 206-686-2211, or click on the “Schedule FREE Consultation” button below.