Case — Like-Kind Exchange

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TL Case Summ

THE QUESTION

Does property received in a like-kind exchange and later converted to a residence qualify for deferral of gain?

THE DISPUTE

Taxpayer Says: The primary purpose in holding the property was for investment, and the gain qualifies for section 1031 like-kind exchange deferral treatment.

Internal Revenue Service Says: The gain from the sale of the property does not qualify for section 1031 like-kind exchange treatment, and should be included in gross income.

THE LAW

From Internal Revenue Code Section 1031(a): Provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind that is to be held either for productive use in a trade or business or investment.

From Moore v. Commissioner, T.C. Memo. 2007-134: Investment intent must be the taxpayer’s primary motivation for holding the exchanged property in order for the property to qualify as “held for investment” under section 1031.

From Bolker v. Commissioner, 81 T.C. 782, 804 (1983): A taxpayer’s intent to hold a property for productive use in a trade or business or for investment is a question of fact that must be determined at the time of the exchange.

From Starker v. United States, 602 F.2d 1341, 1350-1351 (9th Cir. 1979): The use of property solely as a personal residence is antithetical to its being held for investment.

THE CAUSE OF THE DISPUTE

Section 1031 of the Internal Revenue Code is an exception to the general rule that you must recognize gain at the time you sell business or investment property. Under section 1031, you can instead choose to exchange similar (like-kind) property and defer the gain until a later year, when you dispose of the property you receive in the exchange.

There are limitations on the types of property you can exchange, as well as deadlines for completing the exchange, relationship constraints, and restrictions on cash, liabilities and other property you can receive. In addition, some property, such as stocks, bonds and inventory, does not qualify for like-kind exchange deferral treatment.

One reason disputes arise in section 1031 like-kind exchanges is because there is no rule about how long you have to hold a property to prove you initially intended to use it as an investment.

In this case, the taxpayer owned a rental home that he exchanged for two other pieces of property in 2003. Two months after the exchange, when an ad he placed in the newspaper offering to rent one of the new properties was unsuccessful, he moved into the property and used it for his personal residence. Because he tried to rent the property before moving in, the taxpayer says his intent was to hold it as an investment, and that the gain on the sale of the exchanged property qualifies for section 1031 deferred recognition.

The IRS agrees the transaction qualifies as an exchange, that the deadlines and relationship rules were met, and that the property exchanged and one of the properties received were held for investment. However, the IRS contends the property the taxpayer received and converted to use as his principal residence was not held for investment.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 26KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. Efforts to rent the property were not substantial, and the taxpayer failed to meet the burden of proving that at the time of the exchange the primary purpose in holding the property was for investment or for productive use in a trade or business. Consequently, the taxpayer must include the gain on that part of the exchange in gross income for the 2003 tax year.
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