A Potpourri of Section 1031 Issues. Louis S. Weller Deloitte Tax LLP San Francisco, California Telephone:

Transcription

1 A Potpourri of Section 1031 Issues by Louis S. Weller Deloitte Tax LLP San Francisco, California Telephone: Any tax advice included in this written communication was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of avoiding any penalties that may be imposed by any governmental taxing authority or agency.

2 Synopsis Part 1 Vacation Homes under Section 1031 I. General Concepts II. Vacation Homes Held for Business Use III. Vacation Homes Held for Investment Purposes IV. Case Law and Rulings V. Recommendations Part 2 Cost Segregation Issues in Like-Kind Exchanges I. Background II. Property Classification III. Cost Recovery Recapture Issues as a Result of Cost Segregation Part 3 Option Agreements under Section 1031 I. Overview II. Options as Equivalent to Fee Interest in Real Property III. Length of Holding Period and Purpose for Holding Option Part 4 Non-Safe Harbor Reverse Exchanges I. Background II. Case and Ruling Guidance i

3 Part 5 Exchanges by Partnerships When Partners Wish to Separate I. Overview II. All Partners Wish to Separate: Split-Ups III. Additional Possibilities When Only Some Partners Wish to Separate and Receive Cash: Exit Techniques IV. Tax Law Challenges to Split-Up and Exit Techniques ii

4 Part 1 Vacation Homes under Section 1031 I. General Concepts A. In order to qualify for exchange treatment a vacation property must be deemed held for business use or investment purposes under IRC B. Property held solely for personal use and enjoyment is not eligible for 1031 nonrecognition. See, e.g. FSA ; PLR C. IRC 121 exclusion typically not available to vacation homes since they are not taxpayer s principal residence. D. Can vacation homes might still qualify as investment property for purposes of 1031(a) when the investor s personal use is more than minimal or if the home is not rented? E. This issue is highly controversial. Many taxpayers take the position that they are holding their vacation homes for investment purposes and are therefore eligible for exchange treatment regardless of any indication that their ownership is motivated by anything other than personal pleasure use of the property. Rapid appreciation in many vacation and resort areas has lent investment character to marketing of properties in those areas. There is no clearly established rule. II. Vacation Homes Held for Business Use A. IRC 280A governs the deductibility of expenses and depreciation other than mortgage interest and real estate taxes associated with vacation or second home properties when there is both personal use and some rental income and by implication may apply to determine whether such property is held for business purposes under IRC A(a) provides that a taxpayer may not deduct certain expenses associated with business property with respect to a dwelling unit used as a residence by the taxpayer during the taxable year A(d) provides that a taxpayer uses a dwelling unit as a residence if the taxpayer uses the unit for personal purposes for a number of days which exceeds the greater of 14 days, or 10% of the number of days during the year for which such dwelling unit is rented for fair market value. 1

5 a. Personal use for less that these minimums should be strong indication that property is held for trade or business or investment purposes, but there is no specific authority connecting 280A and b. For these purposes, personal use includes the residential use of the unit by persons related to the taxpayer, unless the related persons pay fair market rent. c. Personal use does not include days on which the owner engages in repair and maintenance activities for substantially the whole day. 280A(d)(2). 3. Section 280A(e) makes deductions available which are otherwise barred by 280A(a) on a proportionality concept where a property is both used personally and rented at fair market value. Thus, repairs, maintenance, insurance and depreciation expenses are available but only in the proportion that days rented at FMV bears to days used personally (which include days rented at less than FMV). a. Implication is that only rental days at fair market value rent qualify to convert property from category as residence. i. No comparable standard has been applied to 1031 qualified use test. ii. This seems harsh rule in 1031 context, since business use can be associated with rental at a positive number regardless of whether it is fair market value. b. Proportionality doesn t apply and business deductions are barred if a property taxpayer is deemed to have residential use of a property during a year and rents it for less than 15 days. In this case, rental income is excluded from gross income. 280A(g). c. Upshot is that minimum number of days rented at FMV may be necessary for property to be treated as held for business purposes if the 280A tests apply to i. IRS could take position that anything more than de minimis personal use which converts property to residence for 280A purposes evidences lack of business use. 4. However, it can be persuasively argued that the loss limitation principles associated with 280A are entirely different from the non elective gain 2