Housing Assistance Tax Act of 2008

The Housing Assistance Tax Act of 2008 includes a modification to the primary home exclusion ($250,000 for individuals and $500,000 for married couples) when a property is converted from vacation/investment (“nonqualified”) use to primary (“qualified”) use after December 31, 2008. The gain on the sale of the property will be allocated between the periods of “nonqualified” use and “qualified” use. The $250,000/$500,000 exclusion will be applied to the “qualified” use period only, hence, making the “nonqualified” use period taxable. The nonqualified use prior to January 1, 2009 does not negatively impact the calculation. Conversions from primary use to vacation/investment use do not have the same tax implications and may be afforded 1031 tax deferment.

Disregarded Entities

In a Private Letter Ruling, the IRS ruled the acquisition of a membership interest of a single member disregarded entity did not violate the 1031 prohibition of exchanging into partnership interests. The State of New Hampshire has imposed stricter rules for disregarded entities and may disallow tax deferment at the state tax level.

Related Party Exchanges

Within the 1031 regulations, a taxpayer may sell property to a related party as long as both parties comply with a two-year holding period. A 2002 IRS Revenue Procedure indicated a taxpayer may not buy replacement property from a related party. The more recent IRS PLRs have resulted in favorable outcomes for property disposed of within the two year period and for taxpayers wishing to purchase replacement property from a related party. Although PLRs have no basis in law, it appears the IRS is allowing exceptions to the related party rules where it is evident the parties are not “cashing out” or “basis shifting”. (Related parties include linear relatives and entities in which the Taxpayer owns more than a 50 percent interest. Not related are aunts, uncles, in-laws, cousins, nephews, nieces and ex-spouses.)

Mixed Use Property

In 2005, the IRS issued a Revenue Procedure clarifying the exclusion of tax on properties used for both business/investment use (Section 1031) and as a principal residence (Section 121). The procedure provided guidance and examples for mixed use properties consisting of (a) two separate structures used concurrently, e.g. Duplex, (b) single structure used concurrently, e.g. Boarding house, and (c) single structure used consecutively, e.g. converting a principal residence to a rental property. 

State Tax Issues

Nonresident Withholding Tax - Several states collect an estimated state income/capital gains tax at the time of settlement from nonresident individuals selling a property in their state unless an exemption is requested. Most states grant a partial or full withholding exemption for 1031 exchanges. The states that impose a nonresident withholding tax are: Alabama, California, Colorado, Delaware, Georgia, Hawaii, Maine, Maryland, Mississippi, New Jersey, New York, North Carolina, Oregon, Rhode Island, South Carolina, Vermont and West Virginia.

New Jersey Bulk Sales Transfer Act – In September 2011, the NJ Bulk Sales Transfer Act was amended retroactively to August 2007 to exempt bulk sale notification requirements for one and two family dwellings, a unit in a housing cooperative, a unit in a condominium and a seasonal rental unit owned by an individual, estate or trust. Business use property and ownership not covered in the exemption must adhere to the bulk sale notification requirements but may be granted an escrow exemption if the property is being transferred as part of a 1031 Like-Kind exchange. 

Pennsylvania – Pennsylvania Resident/Pennsylvania Property: Tax deferred exchanges are under IRC Section 1031, a federal regulation. Property sales occurring prior to January 1, 2023; Pennsylvania personal income tax law does not contain a provision analogous to IRC Section 1031. Therefore, sale or exchange of property prior to January 1, 2023 may resulting in gain or income are generally subject to tax. Please consult with your tax advisor with regards to state tax which may be due whether or not you complete a 1031 like-kind exchange.

State “Claw-back” Provisions – A 1031 Like-Kind exchange of a California, Massachusetts, Montana or Oregon property for an out-of-state property is subject to a “claw-back” provision whereby, a tax is due the originating state upon the final sale of the property in the replacement state. This may result in double taxation if both the originating state and the replacement state impose an income tax.

Consumer Protection Qualified Intermediary (QI) Legislation – Several states have enacted legislation to protect consumers from the mishandling of 1031 funds by Qualified Intermediaries. These states include: California, Colorado, Connecticut, Idaho, Maine, Nevada, Oregon, Virginia and Washington.