Category: Real Estate; Nontaxable Exchanges; Individuals Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Facts At some future point, TP may carve out a small portion of the residence, perhaps as much as 25%, to use for rental purposes. Issue Answer Under the facts as I understand them, there is no question that the taxpayer intends to occupy 100% of the second house and use it as his principal residence. The question is whether the conversion of some portion of the residence to rental use at some point after the initial occupancy somehow taints the second residence and prevents it from being deemed a replacement residence under Section 1034. The issue of rental use of an old residence, i.e., the residence the gain from which is being deferred under Section 1034, is widely treated in the tax law. In contrast, there is virtually no mention of rental use of a replacement residence. I cannot locate any case or ruling in which this specific issue is addressed. The regulations at Section 1.1034-1(c) provide if a replacement residence is used in part for business purposes, only the residential portion counts as a replacement residence. Clearly, if a residence is subject to mixed use at the time occupancy, the regulation would require an allocation between business and residential usage for purposes of determining the eligible cost of the replacement. Left unaddressed by the regulation is the issue of conversion to business use after initial occupancy . In this case, the house will be used at the time of TP's initial occupancy 100% for residential purposes. TP has clearly met the requirements of the statute for the replacement residence. There is no indication that a mere possibility of conversion taints the replacement residence. The question ultimately boils down to the length of time TP must wait before carving out a portion of his home for rental purposes. The regulations at Section 1.1034-1(c)(3) provide that whether a residence is a taxpayer's principal residence depends on all the facts and circumstances of each case including the taxpayer's good faith. Revenue Ruling 82-26 deals with sale of a residence a portion of which was used by the taxpayer as a home office. The ruling holds that prior use of the residence as a home office is ignored for Section 1034 purposes as long as no home office deduction is claimed in the year of sale. This ruling implies that the period of time during which business use of a home can affect the taxpayer's ability to use Section 1034 is rather narrow. Note, however, that the ruling deals with a sale rather than a replacement. One can only speculate as to whether the Service intends to apply the same logic to replacement situations. In the end, there is no clear guidance in this matter. I would like to offer the following observations and suggestions.
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