IRS Revenue Procedure 2008-16: What It Means for 1031 Exchanges

If you’re considering a 1031 exchange, you may hear IRS Revenue Procedure 2008-16 mentioned. What does this mean for investors and brokers? 

Issued in March 2008, IRS Rev. Proc. 2008-16 provides a safe harbor for treating certain vacation homes and second homes as property held for investment purposes in a 1031 exchange. Since these guidelines were issued, the IRS generally won’t challenge the property's qualifying use if the taxpayer owns it for at least 24 months immediately before or after the exchange, depending on whether it is the relinquished or replacement property.

When it comes to personal use, investors are limited to no more than the greater of 14 days or 10% of the days the property is rented during the year.

What Rules Does IRS Rev. Proc. 2008-16 Establish?

To create a safe harbor for investors, IRS Rev. Proc. 2008-16 shifted the 1031 space, establishing:

1. Ownership Period: Investors must own for at least 24 months before or after a 1031 exchange.

2. Rental Requirement: The property must be rented out at fair market value for at least 14 days in each of the 12- calendar month periods preceding the exchange.

3. Personal Use Limit: Investors may use the property for no more than 14 days in each 12-month period preceding the exchange or 10% of the days rented.

4. Applicable Properties: Vacation homes and second homes with mixed personal and rental use.

Below is the full text of 2008-16.

(Rev Proc 2008-16)

SECTION 1. PURPOSE

This revenue procedure provides a safe harbor under which the Internal Revenue Service (the Service) will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of 1031 of the Internal Revenue Code.

SECTION 2. BACKGROUND

.01 Section 1031(a) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment (relinquished property) if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment (replacement property). Under 1.1031(a)-(1)(a)(1) of the Income Tax Regulations, property held for productive use in a trade or business may be exchanged for property held for investment, and property held for investment may be exchanged for property held for productive use in a trade or business.

.02 Rev. Rul. 59-229, 1959-2 C.B. 180, concludes that gain or loss from an exchange of personal residences may not be deferred under 1031 because the residences are not property held for productive use in a trade or business or for investment.

.03 Section 2.05 of Rev. Proc. 2005-14, 2005-1 C.B. 528, states that 1031 does not apply to property that is used solely as a personal residence.

.04 In Moore v. Commissioner, T.C. Memo. 2007-134, the taxpayers exchanged one lakeside vacation home for another. Neither home was ever rented. Both were used by the taxpayers only for personal purposes. The taxpayers claimed that the exchange of the homes was a like-kind exchange under 1031 because the properties were expected to appreciate in value and thus were held for investment. The Tax Court held, however, that the properties were held for personal use and that 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.

.05 In Starker v. United States, 602 F.2d 1341, 1350 (9th Cir. 1979), the Ninth Circuit held that a personal residence of a taxpayer was not eligible for exchange under 1031, explaining that [it] has long been the rule that use of property solely as a personal residence is antithetical to its being held for investment.

.06 The Service recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. In the interest of sound tax administration, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under 1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes.

SECTION 3. SCOPE

.01 In general. This revenue procedure applies to a dwelling unit, as defined in section 3.02 of this revenue procedure, that meets the qualifying use standards in section 4.02 of this revenue procedure.

.02 Dwelling unit. For purposes of this revenue procedure, a dwelling unit is real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities.

SECTION 4. APPLICATION

.01 In general. The Service will not challenge whether a dwelling unit as defined in section 3.02 of this revenue procedure qualifies under 1031 as property held for productive use in a trade or business or for investment if the qualifying use standards in section 4.02 of this revenue procedure are met for the dwelling unit.

.02 Qualifying use standards.

(1) Relinquished property. A dwelling unit that a taxpayer intends to be relinquished property in a 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the qualifying use period); 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.

For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).

(2) Replacement property. A dwelling unit that a taxpayer intends to be replacement property in a 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the qualifying use period); and

(b) Within the qualifying use period, in each of the two 12-month periods immediately after 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.

For this purpose, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.

.03 Personal use. For purposes of this revenue procedure, 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 under 280A(d)(2) (taking into account 280A(d)(3) but not 280A(d)(4)).

.04 Fair rental. For purposes of this revenue procedure, whether a dwelling unit is rented at a 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.

.05 Special rule for replacement property. If a taxpayer files a federal income tax return and reports a transaction as an exchange under 1031, based on the expectation that a dwelling unit will meet the qualifying use standards in section 4.02(2) of this revenue procedure for replacement property, and subsequently determines that the dwelling unit does not meet the qualifying use standards, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange under 1031.

.06 Limited application of safe harbor. The safe harbor provided in this revenue procedure applies only to the determination of whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under 1031. A taxpayer utilizing the safe harbor in this revenue procedure also must satisfy all other requirements for a like-kind exchange under 1031 and the regulations thereunder.

SECTION 5. EFFECTIVE DATE

This revenue procedure is effective for exchanges of dwelling units occurring on or after March 10, 2008. No inference is intended with respect to the federal income tax treatment of exchanges of dwelling units occurring prior to the effective date of this revenue procedure.

SECTION 6. DRAFTING INFORMATION

The principal author of this revenue procedure is J. Peter Baumgarten of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding this revenue procedure contact Mr. Baumgarten at (202) 622-4920 (not a toll free call).

Please contact us for additional information.

Are There Common Misconceptions of IRS Rev. Proc. 2008-16?

There are several misconceptions among investors and brokers regarding IRS Rev. Proc. 2008-16 and 1031 exchanges.

1. All Vacation Homes Qualify: The legislation creates a safe harbor only for the “held as an investment” question. Even then, the property must meet specific ownership, rental, and personal-use tests to satisfy Section 1031 requirements.

2. The 24-Month Rule Only Applies Before the Exchange: For relinquished property, the dwelling unit must be owned for at least 24 months immediately before the exchange, but for replacement property, the 24-month qualifying period runs immediately after.

3. 14 Rental Days is Enough: IRS Rev Proc. 2008-16 requires 14 or more fair-market rental days in each 12-month period preceding the exchange throughout the year. Renting below the threshold will not be enough to satisfy the requirements.

4. Personal Use is Not Allowed: Limited personal use is allowed for certain properties under IRS Rev. Proc. 2008-16.

Have a question about you or your client’s 1031 exchange? Contact the First American Exchange Company team today to discuss your options, including Rev. Proc. 2008-16 advantages.