Let's look at short sales.
If you're considering a short sale, how could you have capital gains taxes to defer? Believe it or not, if you have a low enough cost basis in your investment property, you may still owe capital gains taxes, even if you short sale the property!
How could this happen?
Consider the situation where an investor refinanced an investment property to pull out cash and is now upside down on the payments. Let's say this investor now wants to do a 1031 exchange to defer the capital gains. The problem is how are they going to get a loan on the replacement property after short selling the property they sold?
It's possible, but we encourage investors to contact their tax advisors to help them decide what's best for them first.
On February 15, 2008, the Internal Revenue Service issued a revenue procedure, Rev. Proc. 2008-16, which provides new safe harbor rules for dwelling units under Section 1031 of the Internal Revenue Code. These rules became effective March 10, 2008.
A "dwelling unit" is defined as "real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities."
In essence, if the taxpayer is contemplating a 1031 exchange of a dwelling unit, which includes vacation homes and second residences, you should qualify the transaction by conducting an analysis of the facts. The threshold question is whether the dwelling unit, in the past 24 months, has been used solely as a personal residence.
If the property has been used solely as a personal residence, it does not qualify for tax-deferment under Section 1031. If, on the other hand, the property has been rented at a fair rental value during each of the preceding two 12 month periods and personal use of the dwelling unit does not exceed the greater of 14 days or 10% of the number of days the property was rented at a fair rental value during each of the preceding two 12 month periods, the property could qualify under 1031.
Provided that the following rules and guidelines are followed, the IRS will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031:
Example 1: Taxpayer has owned the dwelling for at least 24 months prior to the exchange. In each of the last two years, he rents the dwelling unit at fair rental value for at least 14 days and his personal use for each year does not exceed 14 days. This property would qualify for exchange under IRC §1031.
Example 2: Taxpayer has owned the dwelling for at least 24 months prior to the exchange. In each year, he rents the dwelling unit at fair rental value for 270 days and he uses the property for personal use for 27 days. This property would qualify for exchange under 1031 because the personal use did not exceed 10% of the number of days during the 12 month period the property was rented at fair rental value.
Example 3: Taxpayer has owned the dwelling for at least 24 months prior to the exchange. In each year, he rents the dwelling unit at fair rental value for 270 days and he uses the property for personal use for 30 days. This property would not qualify for exchange under 1031 because the personal use exceeded 10% of the number of days the property was rented at fair rental value.
The revenue procedure also defined the following:
Personal use. Personal use of a dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes.
Fair rental. Fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the parties to the rental agreement are taken into account.
This information is provided by The Private Exchange Group, Inc. as a general guide to understanding the new Rev. Proc. 2008-16 only. The Private Exchange Group, Inc. does not give legal or tax advice. You should contact your attorney, accountant or other financial advisor for legal and/or tax advice.
