April 2012 Archives

April 16, 2012
Posted by Michael Brooks

A Little More On When a Canadian May Sell His Palm Springs Vacation Home and Not Pay US Tax...

Before we show mathematical examples of how a 1031 exchange works, let's look a little more at when a Canadian snowbird may exchange their Palm Springs home (which we are assuming has appreciated in value) for a new Rancho Mirage home, and not pay any US tax. Recall the problem is that home must be "used in trade or business" or "held for investment" in order to be eligible for 1031 tax free exchange treatment. The IRS does not generally view the typical vacation house as either used in trade or business or held for investment. However, the IRS did issue a safe harbor in Revenue Procedure 2008-16, which states that vacation properties may qualify for a 1031 if:
(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) 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 addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use).

But keep in mind, Rev. Proc. 2008-16 is just a safe harbor, you don't have to fit within its confines to get 1031 tax free exchange treatment, right? Well, it is possible for a vacation home to qualify for 1031 exchange even if the owner uses the house more than 14 days a year (for example). But it is the IRS' position that if only the owner (and/or his or her relatives) uses the property (and never rents it out to unrelated individuals), 1031 tax free exchange treatment is not available. And while the IRS' position is not necessarily the bottom line, taxpayers (including Canadian snowbirds) must be prepared for the IRS to challenge any occasion where the taxpayer claiming 1031 tax free treatment does not fit within the confines of Rev. Proc. 2008-16.

So when can the Canadian snowbird unequivocally own an appreciated US property and exchange it for another US property and not pay taxes under 1031? Clearly if the Canadian snowbird bought a Palm Springs house, and does not use it personally and strictly rents it out to (unrelated) individuals, then 1031 treatment is available. That is a good example of where the property is clearly used as a trade or business. What about the other permissible use under 1031: holding for investment? There is no clear test for this. The taxpayer must be prepared to show the primary motive in owning the vacation home is profit, and not personal use. The taxpayer who uses the property a lot personally (even though they may have a big desire for profit) will lose the primary motive is profit argument. A dual goal of personal use and profit will not qualify under 1031. Also, abandoning the house for personal use and then trying to sell it shortly thereafter (and claiming it is now held primarily for investment) is likely not sufficient under 1031 (although holding the property for a while after abandoning it for personal use may work...see Moore v CIR (2007)). In short, the Canadian snowbird must prepared to argue the overwhelming primary motive in buying and holding the Palm Springs home is profit, not personal use. This is very difficult to do (unless the Canadian snowbird or his or her relatives really don't use the property at all). If at all possible, fit within the safe harbor of Rev. Proc. 2008-16.

Next entry, we'll get to the computations....

April 14, 2012
Posted by Michael Brooks

How Do I Sell My House, Buy Another, and Not Pay Tax?

We're taking a break from speaking about the FBAR amnesty program (we will return to this topic shortly), but were going to continue to parallel (for now) our Canadian Snowbird Blog. So the topic at hand is how do I sell my house (we're assuming the house has gone up in value), buy a new house, and not pay tax? Let's assume, for the sake of discussion, that I sell a La Quinta home which has appreciated in value by $500,000 since I bought the house in 1997.

Question #1- Can I sell the house in La Quinta (for $500k more than he bought it for) and buy the Palm Desert replacement property without paying any US tax?
The general answer is yes. Internal Revenue Code Section 1031allows me to exchange, tax free, US real property for other US real property, if several requirements are met.

Question #2- What are the general requirements for a Section 1031 exchange?
In order for me the taxpayer to exchange real property for other real property, and not pay tax:
A) The Property must be exchanged for "like-kind" property. "Like-kind" simply means that real property must be exchanged for real property. But Section 1031 also mandates both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Thus, I cannot exchange into or out of my own personal residence, because that is not deemed held for productive use in a trade or business or for investment. Vacation homes may qualify if they are rented out to unrelated persons, or held primarily for investment rather than personal use. For example, in the 2007 case of Moore v. CIR, the Tax Court held that an exchange of vacation homes did not qualify for nonrecognition under § 1031(a)(1) because neither home was held for investment: "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." Subsequent to the Moore case, the IRS issued Rev. Proc. 2008-16, which provides vacation properties may qualify for a 1031 if:
(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) 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 addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use). So if I have a vacation home for (primarily) personal use, I will have a difficult time taking advantage of Section1031 tax free exchange treatment.
B) It's not as simple as selling my property one day (let's assume for a gain), and buying a replacement property down the road, and not paying tax on the gain. First, the replacement property must be identified not later than 45 days after the sale of the first property. What does it mean to indentify a property? You identify a property in writing, giving the writing to an independent party (a qualified intermediary). Second, the replacement property must be received not later than 180 days after the sale.
We'll pick it up here in our next post, reviewing some examples of how the tax treatment works....

April 4, 2012
Posted by Michael Brooks

Are Canadians Eligible To Exchange US Real Estate in a Tax Free Transaction (a Section 1031 Transaction)?

We've been on a little bit of a break for the busy "season" of February, March and into April. Let's also take a break from talking about the FBAR amnesty program (we will return to this topic shortly).

A question we frequently get comes from a Canadian snowbird who owns (for example) a house in La Quinta. The Canadian then wants to sell the La Quinta property, and purchase a Palm Desert property to take its place. Let's assume, for the sake of discussion, that the La Quinta home the Canadian snowbird is selling has appreciated in value by $500,000 since the snowbird bought the house in 1997 (we will think optimistically).

Question #1- Can our Canadian citizen sell the house in La Quinta (for $500k more than he bought it for) and buy the Palm Desert replacement property without paying any US tax?

The general answer is yes. The nonrecognition provisions of Internal Revenue Code Section 1031 apply to the disposition of a United States real property only if the United States real property is exchanged for other United States real property. But real property located in the United States and foreign real property are not property of like-kind, and therefore do not qualify for Section 1031. So our Canadian snowbird cannot sell the La Quinta house and purchase a Vancouver house and receive Section 1031 nonrecognition treatment.

Question #2- What are the general requirements for a Section 1031 exchange?

In order for a taxpayer (whether American, Canadian, or from any other country) to exchange their property in the US for another property in the US, and not pay tax:

A) The Property must be exchanged for "like-kind" property. "Like-kind" simply means that real property must be exchanged for real property. But Section 1031 also mandates both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Thus, the taxpayer cannot exchange into or out of the taxpayer's own personal residence. Vacation homes may qualify if they are rented out by the taxpayer to unrelated persons, or held primarily for investment rather than personal use. The Canadian snowbird needs to watch this requirement carefully. For example, in the 2007 case of Moore v. CIR, the Tax Court held that an exchange of vacation homes did not qualify for nonrecognition under § 1031(a)(1) because neither home was held for investment: "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." Subsequent to the Moore case, the IRS issued Rev. Proc. 2008-16, which provides vacation properties may qualify for a 1031 if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) 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 addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use). So Canadian snowbirds with a vacation home for(primarily) personal use will have a difficult time taking advantage of Section1031 tax free exchange treatment.

B) It's not as simple as selling your property one day (let's assume for a gain), and buying a replacement property down the road, and not paying tax on the gain. First, the replacement property must be identified not later than 45 days after the sale of the first property. What does it mean to indentify a property? You identify a property in writing, giving the writing to an independent party (a qualified intermediary). Second, the replacement property must be received not later than 180 days after the sale.

We'll pick it up here in our next post, reviewing some examples of how the tax treatment works....