Financial Resource

2008-16 makes it clear that if, with respect to the replacement property, the taxpayer does not meet the ‘ownership and use’ requirements imposed by Rev. Proc. 2008-16, the taxpayer will be expected to file an amended tax return to remain within the safe harbor, for the taxable year in which the exchange was completed, and report, on such return, the gain derived from the exchange.

What Is a ‘Dwelling Unit’

In many situations, the Service views the absence of guidance as a more effective deterrent to abuse than publication of guidance. The Treasury Department felt it necessary to clarify the requirements and deter the perceived abuses of the system. The Rev. Proc. does appear to clarify the situation on the qualification of second homes, but also opens a Pandora’s box on many other key 1031 principles.

The Rev. Proc. specifies that it is only applicable to dwelling units, but leaves unanswered questions such as whether there is a differentiation between a rental property, second home and vacation home. Although the Treasury Department report did cite concerns about taxpayer abuse related to IRC §121 exemptions, the report’s recommendation was to provide ‘additional guidance to taxpayers regarding the rules and regulations governing like-kind exchanges with respect to second and vacation homes that were not used exclusively by owners.’

The Rev. Proc., as issued, appears to be much broader than anticipated.

Both rental properties and second homes will likely fall under the classification of a ‘dwelling unit.’ However, there are important distinctions that can be made between them: A second home has a potential intent of some personal use, while a rental property will likely have no intended personal use, with the primary intention of rental purposes.

From an industry standpoint, a true rental property was perceived to qualify as an investment property, regardless of whether the taxpayer was able to find a tenant, given that the owners’ true intent is the income or appreciation opportunity of the property with no intentions of personal use. Under Rev. Proc. 2008-16, there is a requirement for safe harbor purposes that the property is actually rented regardless of the taxpayer’s true intent.

This appears to create a quandary for those taxpayers who have a true investment intent pertaining to the ownership of the property, but for reasons such as the deflated economy have been unable to rent it. The Rev. Proc. undermines the fundamental principle of ‘investment intent’ while also potentially contradicting Treas. Reg. 1.1031(a)-1(b) which states that ‘unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment.’ The Rev. Proc. removes the concept of intent and replaces it with actual rental time, which is a material shift in philosophy.

Length of Holding Period

Although the Rev. Proc. is a safe harbor for dwelling units and thereby limited in scope and application, it stands to have a much more profound effect on the industry.

As previously mentioned, many times the Service views the absence of guidance as a more effective deterrent to abuse than publication of guidance. Taxpayers and their advisors will typically look to the Code, as well as revenue procedures, Tax Court decisions and private letter rulings as a gauge of the administration’s position on varying issues that may not be clearly defined in §1031. Therefore, the release of a safe harbor ruling on second homes is likely to have a profound impact on the much broader 1031 industry to the extent it touches upon universal requirements and concepts.

One such area could be the applicable holding period specified in Rev. Proc. 2008-16. It requires a 24-month hold period on both the relinquished and replacement properties. There is a general view in the industry that a one-year hold period should be sufficient to show an investment intent. Although the authors are not against the Service clarifying a specified hold period, we are not sure that the intent, nor the considerations, in preparation of the Rev. Proc. were to establish a time period to qualify for 1031.

Although the procedure is limited in application, the taxpayer will likely have to ‘read between the lines’ as to the intent of the Service in specifying such a time requirement. To say that this has no impact is not fair, given that such a universal time parameter for qualifying as an investment property should not really differ from one property type to another.

How should one view the exchange of a property under two years given the safe harbor requirements of 2008-16? Was this an intended action, or inadvertently incorporated into the fold?

Amended Tax Returns

Lastly, further evidence of a shift in philosophy is the subtle, yet powerful statement included in Rev. Proc. 2008-16 §4.05, ‘Special rule for replacement property.’

The section suggests that a taxpayer purchasing a replacement property expecting to meet the qualifications, but who in actuality does not, ‘if necessary, should file an amended return and not report the transaction as an exchange.’ Once again, this is a dramatic shift from the concept of investment intent.

The Rev. Proc. is stating that taxpayers with true intentions to meet the qualifications, but who for one reason or another shift their usage of the property, or potentially are forced to sell it within a 24-month period, should amend their tax returns and recognize the gain on the original sale of the relinquished property.

Although trying to protect against abuses of the system, this self-disqualification requirement may place an unfair burden on taxpayers who truly set out with the intention of adhering to the qualification of an investment property, but over time change their utilization of the property due to unforeseen circumstances.

Conclusion

In many instances where there is a lack of guidance by the Service, taxpayers are in a position of being unclear as to whether their transactions would qualify for the benefits of §1031.

In that regard, the industry applauds the issuance of guidance to clarify such situations. However, Rev. Proc. 2008-16 appears to open up many additional issues in its attempt to merely clarify exchanges of vacation homes, which may have unintended consequences.

The guidance will likely give rise to many other situations, which may or may not fall under the scope of Rev. Proc. 2008-16, whereby taxpayers are left in a very difficult position of assessing the qualifications of their property. There are many foreseeable situations whereby taxpayers with true qualifying intent may be inclined to pass upon the benefits afforded to them through §1031 because of the ambiguities of Rev. Proc. 2008-16.

Although such unfair burdens were likely not intended by the Rev. Proc., the attempts to clarify one issue will have a much broader impact than the initial undertaking, and likely create many other unclear situations.

Those taxpayers considering the sale and exchange of a dwelling unit of any type will definitely want to consider the implications of the Rev. Proc. and plan accordingly. It appears that while certain questions have been answered, there will need to be further clarification for numerous circumstances.

Todd R. Pajonas is president of Legal 1031 Exchange Services Inc. and Matthew K. Scheriff is executive vice president and a principal of the company.

Legal 1031 Exchange Services, Inc.

877/701-1031

todd@legal1031.com

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