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….