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Like-kind exchanges of mixed-use property: spotlight on bed and breakfast inns.

Under IRC section 1031, a taxpayer's exchange of real property used in a trade or business or held for investment for other like-kind property will generally result in nonrecognition of gain. In some situations, a taxpayer may exchange "mixed-use" property, in which a portion of the property is either used in a trade or business or held for investment. If the taxpayer uses the remaining portion of the mixed-use property as a principal residence, it is possible for the taxpayer to bootstrap the provisions of IRC section 121 to section 1031.

[ILLUSTRATION OMITTED]

Bed and breakfast (B&B) inns, farms with principal residences, and principal residences with home offices are all examples of mixed-use property. The illustrative example that follows will focus on a section 1031 exchange involving a B&B. One of the authors recently structured such a transaction and dealt with many of the practical aspects and nuances of such a situation. The impact of the Housing and Economic Recovery Act of 2008 will also be examined.

Sale of Residence Under IRC Section 121

A married couple filing jointly can exclude up to $500,000 of realized gain upon the sale of a principal residence on or after May 7, 1997, if certain criteria are met. Taxpayers filing singly or separately can exclude up to $250,000. To qualify for the maximum applicable exclusion, a taxpayer must generally have owned and used the home as a principal residence for at least two years of the five-year period ending on the date of sale. (In addition, the taxpayer cannot have excluded gain on the sale of another principal residence within two years. It is not necessary for the periods of ownership and use to have been coextensive, nor is it necessary for the property to be the taxpayer's principal residence at the time of sale.) In some situations, a taxpayer who does not satisfy the two-year ownership and occupancy requirements under IRC section 121 can qualify for a reduced exclusion under section 121(c). (This rule, generally applicable to sales "by reason of a change in place of employment, health, or to the extent provided in the regulations, unforeseen circumstances," is further clarified in Treasury Regulations section 1.121-1.)

Nonqualified Use

The Housing Act of 2008 contains a provision that may, in some situations, affect a sale or exchange of a principal residence. Under IRC section 121(b)(4)[(5)], the exclusion of gain shall not apply to the portion of the gain allocated to periods of nonqualified use. A period of nonqualified use means "any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or taxpayer's spouse or former spouse" [IRC section 121(b)(4)[(5)](C)(I)]. The term "period of nonqualified use" does not include the following:

* any portion of the five-year period described in IRC section 121(a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer's spouse;

* any period (not to exceed an aggregate period of 10 years) during which the taxpayer or the taxpayer's spouse is serving on qualified official extended duty; and

* any other period of temporary absence (not to exceed an aggregate period of two years) due to change of employment, health conditions, or other unforeseen circumstances [IRC section 121(b)(4)[(5)] (C)(ii)(I)-(III)].

For the purposes of allocating gain to nonqualified use, the gain is multiplied by a ratio, the numerator of which is the post-2008 aggregate period of nonqualified use, and the denominator of which is the period such property was owned by the taxpayer. Gain allocated to nonqualified use is not excluded from income under IRC section 121.

IRC section 121(b)(4)[(5)] is applied after the depreciation rule in section 121(d)(6). Under this rule, the gain excluded under section 121 is reduced by depreciation allowable after May 6, 1997.

Example. A married couple filing jointly buys a rental property on January 1,2011, and uses it as a rental property for three years. On January 1, 2014, the taxpayers convert the property to a principal residence. They live in the principal residence for two years and then sell it on January 1,2016, for $952,500. Assume that the depreciation claimed on the property is $52,500 and the adjusted basis at the time of sale is $500,000. The depreciation will be taxed at a rate of 25%. Of the remaining gain of $400,000, 60% (three years of nonqualified use divided by five years of total use) will be allocated to nonqualified use and will be taxed at no more than the maximum long-term capital gains rate (currently 15%). The reduced section 121 gain exclusion will be $160,000 (40% of $400,000).

Bed and Breakfasts

A B&B is typically contained within one building or real estate parcel, a portion of which is used for personal purposes and the other for business purposes. Taxpayers can generally deduct business expenses that are directly allocable to those rooms used exclusively in the business portion of the establishment [see IRC section 280A(1) and IRS Letter Ruling 8732002]. In the alternative, a taxpayer can allocate business use based upon the square footage used exclusively for business. The percentage of the property attributed to the business use is then used to partition mortgage interest, insurance, utilities, and repairs and maintenance expenses.

The rooms or square footage used exclusively in the business activity are not considered residential property. Accordingly, the sale of a B&B can be partitioned as part residential property and part business property. In many situations, a taxpayer can exclude gain on the residential portion under IRC section 121 and defer recognition of gain on the business portion under the like-kind exchange provisions of section 1031. However, where a taxpayer owns a B&B, hires an onsite property manager to manage it, and then later decides to convert some or all of its use to a principal residence, the taxpayer's later sale of the principal residence may result in a reduced exclusion under section 121(b)(4)[(5)].

Example. A married couple filing jointly buys a B&B on January 1, 2011, and hires a third party to live in and manage the B&B. During the next two years, no portion of the B&B is used as the taxpayers' principal residence. The couple then converts the B&B to a personal residence and uses it as such for next three years. On January 1, 2016, the taxpayers sell the principal residence for $930,000. Assume that the adjusted basis of the property at the time of sale is $500,000 and that the depreciation claimed on the property is $30,000 (all of which is related to business use). Of the remaining gain of $400,000, 40% (two years of nonqualified use divided by five years of total use) will be allocated to nonqualified use. The reduced IRC section 121 gain exclusion will be $240,000 (60% of $400,000).

As a practical matter, the act of converting mixed-use property to a principal residence would tend to decrease the value of the property itself. In most situations, it would not make sense--from either a financial or tax standpoint--to convert property used as a B&B to a principal residence, unless business conditions indicated otherwise.

Like-Kind Exchanges Under IRC Section 1031

To qualify for IRC section 1031 gain deferral treatment, the property transferred and the property acquired must be of a like-kind and held for productive use in a trade or business or for investment purposes (i.e., rental property). Both the property relinquished and the property acquired must be qualifying property.

Most like-kind exchanges involve real estate. The real estate may be improved or unimproved, as long as it is held for investment or for income-producing purposes. Unimproved property can be replaced with improved property. For example, under IRC section 1031, real property improved with a residential rental house and vacant land are considered to be like-kind property (www.irs.gov/newsroom/article/0,,id=179801,00.html).

Real estate that does not qualify for IRC section 1031 exchange treatment includes personal residences (and other personal-use property, such as a second home or vacation home), land under development for resale, and real property held as inventory. In addition, foreign real estate exchanged for U.S. real estate does not qualify for section 1031 exchange treatment. The portion of the property held for use in a trade or business or held for investment must be exchanged for other property held for use in a trade or business or held for investment. The amount of gain deferred under IRC section 1031 is not subject to the $250,000/$500,000 limits of section 121.

A 100% interest can be exchanged for an undivided percentage interest with multiple owners. Revenue Procedure 2002-22 permits the use of an interest in an asset held as a tenancy in common (TIC) in a like-kind exchange. One property can be exchanged for two or more properties. Two or more properties can be exchanged for one property. A duplex can be exchanged for a fourplex. Investment property can be exchanged for business property and vice versa.

Any cash received, fair market value (FMV) of other property received, plus net liabilities assumed by another party, reduced (not below zero) by any exchange expenses the taxpayer incurred, is considered "boot" and will be taxable to the extent of the lesser of the FMV of the boot received or gain realized on the exchange (see IRS Form 8824, Part III, line 15).

In general, any additional cash that a taxpayer pays for the replacement property or debt retired from personal funds will not force the recognition of gain, as long as the entire sale price of the relinquished property is reinvested into replacement property (see Form 8824, Part III).

Where the taxpayer transfers like-kind property and receives cash or other consideration (e.g., boot) in addition to the replacement property, gain recognition will result to the extent of the lesser of the realized gain or the fair market value of the boot received.

"Boot" is not defined in the tax code, but it is commonly used in discussing the tax consequences of an IRC section 1031 tax-deferred exchange. Boot is the money, the FMV of other property, or the net liability relief received by the taxpayer in an exchange. "Other property" is property that is not like-kind in nature. (For example, personal property and real property are not like-kind.) A common misconception is that the same amount or greater amount of debt must be maintained in the exchange. This is not true if the taxpayer chooses to reduce debt by investing more cash in the exchange.

To avoid recognizing capital gains, a taxpayer should exchange property for replacement property of equal or greater value. When the taxpayer reinvests an amount less than the FMV of the relinquished property into replacement property, a portion of the gain on the exchange will generally be taxable. Trading down always results in boot received, either cash or other non-like-kind consideration, debt reduction, or both. Boot received can, however, be mitigated by exchange expenses paid on the transaction.

Interplay of Sections 121 and 1031

Neither IRC section 121 nor section 1031 addresses the interplay of these provisions to a single exchange of property. IRC section 121(d)(5)(B) does provide such rules with respect to section 121 and the nonrecognition rule for involuntary conversions under section 1033. The legislative history of IRC sections 121 and 1033 indicates the following:

* For exchanges meeting the requirements of both section 121 and section 1033, the section 121 exclusion should be applied to gain from the exchange before the application of section 1033;

* For purposes of determining gain that may be deterred under section 1033, the section 121 exclusion should be applied first against amounts received by the taxpayer that are not reinvested in the replacement property (i.e., amounts equivalent to boot that would result in gain recognition absent section 121); and

* The gain excluded under section 121 should be added in the calculation of the taxpayer's basis in the replacement property. [See S. Rep. No. 830, 88th Congress, 2d Session 52-53, 1964-1 C.B. (Part 2) 505, 556-7; H.R. Rep. No. 749, 88th Congress, 1st Session 47, 1964-1 C.B. (Part 2) 125, 171.]

Revenue Procedure 2005-14 takes a similar approach when examining the interplay of IRC sections 121 and 1031. An exchange of a mixed-use property can result in the exclusion of gain under section 121 and nonrecognition of gain under section 1031 as follows:

* The IRC section 121 exclusion is applied to exclude gain prior to applying section 1031 to defer gain recognition.

* The IRC section 121 exclusion does not apply to gain attributable to depreciation deductions for periods after May 6, 1997, claimed with respect to the business or investment portion of a residence. IRC section 1031 may apply to defer such gain.

* In applying IRC section 1031, cash or other non-like-kind property (i.e., boot) received in exchange for property used in the taxpayer's trade or business or held for investment (the relinquished business property), is taken into account only to the extent the boot exceeds the gain excluded under section 121 with respect to the relinquished business property.

* In determining the basis of the property received in the exchange to be used in the taxpayer's trade or business or held for investment (the replacement business property), any gain excluded under IRC section 121 is treated as gain recognized by the taxpayer. Under IRC section 1031 (d), the basis of the replacement business property is increased by any gain attributable to the relinquished business property that is excluded under section 121.

Mixed-Use Swap Involving IRC Sections 121 and 1031

Revenue Procedure 2005-14 contains several examples involving a like-kind exchange of a principal residence that contains a home office. The following examples present the information contained in Examples 3, 4, 5, and 6 of Revenue Procedure 2005-14. These examples, which have been edited or modified by the authors for the sake of simplicity and length, relate to a single unit, a portion of which is used as a principal residence and, the other portion, as a home office. The situations described in these examples should also apply to the like-kind exchange of a single-unit B&B.

Example. Taxpayer C buys a property for $210,000. The property consists of a house that constitutes a single dwelling unit. From 2001 until 2006, C uses two-thirds of the house (by square footage) as a principal residence, and one-third as a home office in C's trade or business. In 2006, C exchanges the entire property for a residence and a separate property that C intends to use in a trade or business. The total FMV of C's replacement properties is $360,000. The FMV of the replacement residence is $240,000, and the FMV of the replacement business property is $120,000, which is equal to the fair market value of the business portion of the relinquished property. From 2001 to 2006, C claims depreciation deductions of $30,000 for the business use. C realizes a gain of $180,000 on the exchange.

Under IRC section 121, C may exclude the gain of $100,000 allocable to the residential portion of the house (2/3 of the $360,000 realized--$240,000--minus 2/3 of the $210,000 basis--$140,000) because C meets the ownership and use requirements for that portion of the property. The remaining gain of $80,000 (1/3 of the $360,000 amount realized--$120,000--minus $40,000 of the adjusted basis, which is 1/3 of the $210,000 basis--$70,000--less the $30,000 of depreciation) is allocable to the business portion of the home. Taxpayer C applies IRC section 121 before applying the nonrecognition rules of section 1031. C may exclude $50,000 of the gain allocable to the business portion because it and the residence are part of a single-dwelling unit. C may not exclude that portion of the gain ($30,000) attributable to depreciation but may defer the remaining gain of $30,000 under section 1031. The results are shown in Exhibit 1.
EXHIBIT 1

Mixed-Use Swap

                          Total    2/3 residential  1/3 business
                         property      property       property

Amount realized          $360,000      $240,000       $120,000

Basis                    $210,000      $140,000       $ 70,000

Depreciation adjustment  $ 30,000             -       $ 30,000

Adjusted basis           $180,000      $140,000       $ 40,000

Realized gain            $180,000      $100,000       $ 80,000

Gain excluded under      $150,000      $100,000       $ 50,000
section 121

Gain deferred under      $ 30,000  -                $ 30,000
section 1031

The taxpayer's basis in the replacement property is $240,000
(residential portion) and $90,000 (business portion--$40,000 adjusted
basis plus $50,000 excluded gain under section 121).


Example: Realized gain less than the maximum section 121 exclusion. Assume the same facts as in the previous example, except that C also receives $10,000 of cash in the exchange, and the FMV of the replacement business property is $110,000, which is $10,000 less than the FMV of the business portion of the relinquished property ($120,000).

Under IRC section 121, C may exclude the gain of $100,000 allocable to the residential portion of the house (2/3 of the $360,000 realized--$240,000--minus 2/3 of the $210,000 basis--$140,000). The remaining gain of $80,000 (1/3 of the $360,000 realized--$120,000--minus the adjusted basis of $40,000) is allocable to the business portion of the house.

Taxpayer C applies IRC section 121 to exclude gain before applying the non-recognition rules of section 1031. C may exclude $50,000 of the gain allocable to the business portion of the house but may not exclude the $30,000 of gain attributable to depreciation. C may defer the $30,000 of gain under section 1031. Although C receives $10,000 in cash (boot) in the exchange, C is not required to recognize gain because the boot is taken into account for purposes of section 1031 (b) only to the extent that the boot exceeds the amount of excluded gain attributable to the relinquished business property. The results are illustrated in Exhibit 2.
EXHIBIT 2

Realized Gain Less than Maximum Section 121 Exclusion

                          Total    2/3 residential  1/3 business
                         property      property        property

Amount realized          $360,000      $240,000       $120,000 *

Basis                    $210,000      $140,000       $ 70,000

Depreciation adjustment  $ 30,000             -       $ 30,000

Adjusted basis           $180,000      $140,000       $ 40,000

Realized gain            $180,000      $100,000       $ 80,000

Gain excluded under      $150,000       $100,000      $ 50,000
section 121

Gain deferred under      $ 30,000             -       $ 30,000
section 1031

* $110,000 plus $10,000
The taxpayer's basis in the replacement property is $240,000
(residential portion) and $80,000 (business portion--$40,000 adjusted
basis plus $50,000 excluded gain under section 121, minus $10,000
boot).


Example: Realized gain greater than the maximum section 121 exclusion (gain not recognized). Assume the same facts as the first example, except that the total FMV of the replacement properties is $540,000. The FMV of the replacement residence is $360,000, the FMV of the replacement business property is $180,000, and C realizes a gain of $360,000 on the exchange.

Under IRC section 121, C may exclude the gain of $220,000 allocable to the residential portion of the home (2/3 of the $540,000 realized--$360,000--minus 2/3 of the $210,000 basis--$140,000).

The remaining gain of $140,000 (1/3 of the $540,000 realized, or $180,000, minus the adjusted basis of $40,000) is allocable to the business portion of the home. C excludes the gain before applying the nonrecognition rules of IRC section 1031. C may exclude $30,000 of the gain allocable to the business portion, at which point C will have excluded the maximum limitation of $250,000. C may defer the remaining gain of $110,000 ($140,000 realized gain minus the $30,000 gain excluded under section 121), including the $30,000 gain attributable to depreciation, under IRC section 1031. The results are illustrated in Exhibit 3.
EXHIBIT 3

Realized Gain Greater than Maximum Section 121 Exclusion (Gain Not
Recognized)

                      Total    2/3 residential  1/3 business
                     property      property         property

Amount realized      $540,000      $360,000         $180,000
Basis                $210,000      $140,000         $ 70,000
Depreciation         $ 30,000             -         $ 30,000
adjustment
Adjusted basis       $180,000      $140,000         $ 40,000

Realized gain        $360,000      $220,000         $140,000

Gain excluded under  $250,000      $220,000         $ 30,000
section 121

Gain deferred under  $110,000             -         $110,000
section 1031

The taxpayer's basis in the replacement property is $360,000
(residential portion) and $70,000 (business portion--$40,000 adjusted
basis plus $30,000 excluded gain under section 121).


Example: Realized gain greater than maximum section 121 exclusion (gain recognized). Assume the same facts as the first example, except that the total FMV of the replacement properties is $750,000. The FMV of the replacement residence is $500,000, the FMV of the replacement business property is $250,000, and C realizes a gain of $570,000 on the exchange.

The gain allocable to the residential portion is $360,000 (2/3 of the $750,000 realized, or $500,000, minus 2/3 of the $210,000 basis, or $140,000). C may exclude a gain of $250,000 from gross income under IRC section 121; however, C must include in income the gain of $110,000 allocable to the residential portion in excess of the section 121(b) exclusion limitation amount.

The remaining gain of $210,000 (1/3 of the $750,000 realized--$250,000--minus the adjusted basis of $40,000) is allocable to the business portion of the house. C may defer the $210,000 of gain, including the $30,000 gain attributable to depreciation, under IRC section 1031. These results are illustrated in Exhibit 4.
EXHIBIT 4

Realized Gain Greater than Maximum Section 121 Exclusion (Gain
Recognized)

                         Total     2/3 residential  1/3 business
                         property      property        property

Amount realized          $750,000      $500,000        $250,000

Basis                    $210,000      $140,000        $ 70,000

Depreciation adjustment  $ 30,000             -        $ 30,000

Adjusted basis           $180,000      $140,000        $ 40,000

Realized gain            $570,000      $360,000        $210,000

Gain excluded under      $250,000      $250,000               -
section 121

Gain deferred under      $210,000             -        $210,000 *
section 1031

Gain recognized          $110,000      $110,000               -

* Including the $30,000 related to depreciation
The taxpayer's basis in the replacement property is $500,000
(residential portion) and $40,000 (business portion--adjusted basis).


Tax Planning Considerations

The examples contained in Revenue Procedure 2005-14 serve as a road map when structuring a like-kind exchange of mixed-use property under IRC sections 121 and 1031. In several of these examples, a properly structured mixed-use swap can give taxpayers an opportunity to receive boot without tax consequences. These examples also help clarify the amount of realized gain allocated between the residential and business portions of mixed-use property and aid in the computation of the basis of the property received in a mixed-use exchange.

The examples contained in Revenue Procedure 2005-14 were issued several years prior to the enactment of IRC section 121(b)(4)[(5)] and, accordingly, do not take into account the new law. Thus, in some situations, it is possible that IRC section 121(b)(4)[(5)] may pose an issue for a partial sale/partial exchange of mixed-use property after 2008.

Opportunities for B&B Owners

IRC section 121 sets forth criteria pursuant to which a taxpayer can exclude up to $250,000 ($500,000 for married couples filing jointly) of gain realized on the sale of a principal residence. Where the property in question is a B&B, questions may arise as to the tax treatment to be accorded the realized gain allocable to the portion of the sale that is not a principal residence. As a general rule, such gain will be recognized up to the amount of the depreciation taken on the portion of the property.

One means of potentially averting recognition of gain attributable to the non-principal-residence portion of a B&B is to have it transferred pursuant to a like-kind exchange. Guidance concerning the like-kind exchange of mixed-use property is set forth in Revenue Procedure 2005-14. This guidance can be quite helpful to a taxpayer seeking to exclude a portion of the gain under IRC section 121 and defer a portion under IRC section 1031.

Barbara Leonard, PhD, CMA, is an associate professor at the University of Hawaii at Hilo. Bruce M. Bird, JD, MST, CPA, is a professor at the Richards College of Business, University of West Georgia, Carrollton, Ga. Mark Segal, JD, LLM, CPA, is a professor at the Mitchell College of Business, University of South Alabama, Mobile, Ala.
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Title Annotation:federal taxation
Author:Leonard, Barbara; Bird, Bruce M.; Segal, Mark
Publication:The CPA Journal
Article Type:Report
Geographic Code:1USA
Date:Oct 1, 2009
Words:4186
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