Many residential real estate investors at some point wonder whether an investment property that was previously the investor’s residence or is later converted into the investor’s residence can qualify for a 1031 exchange. The two recent Tax Court cases of Adams v. Commissioner and Reesink v. Commisioner both indicate that investment properties can include these two residential scenarios.
The Internal Revenue Code imposes taxes whenever property is sold or transferred and a gain is realized. However, according to Section 1031 of the tax code, if a taxpayer adheres to strict code guidelines, then all or a portion of the gains from the disposition of business or investment property can be deferred or reinvested into a new replacement property. These deferred gains, as well as the gains from the new property, are not taxed until the new property is transferred and fails to qualify for tax deferral. To qualify for tax deferment, the taxpayer must structure the transaction as an exchange of one property for another of “like kind”.
Two components of tax are deferred by a 1031 exchange. Firstly, the tax due on the profit earned on the sale of investment or income property, which is generally at a rate of 15%. The profit earned is the appreciation in value of the property and is determined by gross sales price minus the adjusted basis and the cost of sale. Secondly, the tax due on the recapture of depreciation previously taken by the taxpayer during the time the taxpayer owned the property, which is generally at a rate of 25%.
In Adams v. Commissioner (TC Memo 2013-7), the Tax Court found that a like-kind exchange was not barred where the owner’s son moved into the replacement property and paid less than fair market rent, the Court finding that the son was doing extensive renovations as a trade off for rent.
In the Adams case, Mr. Adams purchased a home in 1963 in San Francisco for $26,000 and lived there until 1979. He then continuously rented his San Francisco property until he sold it for $572,000 in 2003. Mr. Adams reinvested the sale proceeds in a home in Eureka, California, which he rented to his son. Mr. Adams did not pay tax on the profit from the sale of the San Francisco home, claiming that the sale of the San Francisco home and purchase of the Eureka home was a 1031 exchange. The IRS disagreed, asserting that the rental arrangement between Mr. Adams and his son was in the nature of a gift, and the Eureka home was not investment property eligible for a 1031 exchange. The Tax Court noted that the son paid fair rental value for the Eureka home, concluded that it was purchased as investment property, and ruled in favor of Mr. Adams.
Reesink v. Commissioner (TC Memo 2012-118) involved a married couple who acquired a residence as replacement property in an exchange and later moved into it without any intervening rental. The court nevertheless upheld the exchange, holding that, based on the facts, the taxpayers acquired the residence primarily for investment.
In the Reesink case, Mr. Reesink and his brother sold a San Francisco apartment building for $1,400,000. Mr. Reesink made a profit of approximately $425,000 and then he purchased a single-family home in Sonoma County, California with the proceeds. After failing to rent the property for approximately eight months, Mr. Reesink and his family moved into the home as their personal residence. Mr. Reesink did not pay tax on the profit from the sale of the San Francisco apartment building, claiming that the sale of the apartment building and purchase of the Sonoma home was a 1031 exchange. The IRS disagreed, asserting that Mr. Reesink purchased the Sonoma home not as replacement investment property, but with the intent to make it his personal residence. The Tax Court noted that Mr. Reesink had attempted to rent out the Sonoma home, concluded that it was purchased as investment property, and ruled in favor of Mr. Reesink.
Notwithstanding the court’s decision in Reesink v. Commissioner, in most instances an owner of replacement investment property should hold it as investment property for two years, considerably more than eight months, to demonstrate investment intent before converting it to an owner’s personal residence.
While investment property that qualified for a 1031 exchange can be converted into an investor’s residence and vice versa, investors who want to convert replacement properties into their residence should focus on documenting their intent instead of solely relying on the length of time a property was owned. For instance, what type of mortgage loan and insurance policy was obtained for the property? How was the property marketed and was it offered at a fair market rental rate? Documenting the circumstances leading to the decision to move into the property and documenting the bona fide efforts to rent the replacement property are essential.
Since 1921, tax-deferred or 1031 exchanges have evolved from a simple but restrictive two-party swap to today’s highly strategic and sophisticated exchanges. Developing the strategy for the purchase or sale of an investment property targeted for a 1031 exchange always requires competent tax and legal advice. Please contact Evelyn Ginossi of IBV Advisory Group Inc. at 310-746-3837 or firstname.lastname@example.org for more information.