Was property purchased as part of a Section 1031 like-kind exchange held for investment?
Taxpayer Says: Though he moved into the replacement property after selling his personal residence, the property was initially purchased as an investment and like-kind exchange treatment should be allowed.
Internal Revenue Service Says: The taxpayer purchased the property to use as a principal residence. Like-kind exchange treatment is not appropriate.
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 for investment.
From Internal Revenue Code Section 1031(a)(3): The property a taxpayer receives in the exchange (replacement property) must be: (1) identified within 45 days of the transfer of the property relinquished in the exchange (relinquished property), and (2) received by the earlier of 180 days after the transfer of the relinquished property or the due date (including extensions) of the transferor’s tax return for the tax year in which the relinquished property is transferred.
THE CAUSE OF THE DISPUTE
One way you can defer recognizing gain on the sale of investment or business property is to structure the transaction as a like-kind exchange (also known as a Section 1031 exchange). In a like-kind exchange, you sell a trade, business or investment property and purchase other, similar property.
To avoid having the exchange taxed as a regular sale and purchase, you have to meet the requirements under Section 1031 of the Internal Revenue Code. Those requirements include two statutory time limits for when the sale and purchase transactions must occur. The first is a 45 day period for identifying replacement property, and the second is a 180 day period for completing the exchange. In addition, the property must be business or investment property, and you must intend to use the replacement property in the same manner–that is, for business or investment.
Disputes arise because there is no specific length of time you have to hold the property you purchase as a replacement in order to prove you intended to use it for business or investment.
In this case, the taxpayer sold an apartment building and purchased a single family residence within the statutory time limits to qualify as a Section 1031 exchange. He did not report gain from the sale of the apartment building.
He attempted to rent the single family residence for $3,000 per month via advertisements in newspapers and flyers, and he showed the property to potential renters. Though the property was never rented, the taxpayer did not lower the amount asked for the monthly rent.
Around the time of the purchase of the single family residence, the taxpayer’s income declined due to a disability. Eight months after the purchase, concerned that he could not maintain the rental, his home, and another property he owned, he sold his primary home and moved into the single family residence.
While agreeing the timing requirements of Section 1031 were met, the IRS says the taxpayer did not purchase the single family residence with the intent to use it as a rental. The IRS points to the fact that the taxpayer had other assets available and could have taken multiple other actions instead of moving into the single family residence, and argues the taxpayer bought the home to use as his personal residence. Since the replacement property was not purchased for investment purposes, the purchase does not qualify as part of a like-kind exchange and the gain from the sale of the apartment building should be recognized and taxed.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
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.
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