A 1031 exchange is fraught with rules and requirements that, if not followed can result in an IRS audit, penalty and tax bill. Known as a like-kind exchange, the Internal Revenue Code (IRC) Section 1031 allows the deferral of federal and state capital gain and depreciation recapture when property either real or personal held in the productive use of a business or for investment is exchanged solely for property held for productive use in a business or for investment. The 1031 exchange effectively postpones the payment of the tax until the replacement property is sold and another 1031 exchange is not initiated. The strategy is recognized by the Treasury Department and enforced by the Internal Revenue Service.
Like-Kind Property
Eligible property excludes primary residence, inventory, partnership interests, indebtedness and stocks and securities. In my practice as a Qualified Intermediary, I accommodate land, thirty year leaseholds, mineral royalties, commercial and single family properties to aircraft, vintage and collectible sports cars, gold and silver bullion, artwork, livestock, franchise rights, business sales and equipment, including carnival rides. Like-kind implies any real property for any real property given the state where the old or relinquished property is located recognizes the property as real property. Personal property is less liberal where the asset class or North American Industry Classification System (NAICS)-group of the property sold is the same as the replacement property.
Vacation Property and Family Use
Condominiums and vacation properties have been aggressively exchanged with taxpayers–and at times, their tax counsel–assuming that an intent for appreciation is adequate to qualify for a 1031 which is woefully short of the bar. For vacation properties the rulebook was further qualified in Revenue Procedure 2008-16 to provide a bright line test discussed in the following brief article.
With the exception of fourteen overnights for each of two years, a related party (spouse, parents, lineal descendants) is not permitted to rent the vacation property even at fair market value.
A related party can rent a residential property as their primary residence.
1031 Proper Intent and Fact Pattern
In every 1031 exchange the intent is critical when the property is initially acquired as supported by a substantiated fact pattern to hold the property in the productive use of a business or for an investment. Intents can change, but the fact pattern, including how the property is itemized on the taxpayer’s federal tax return whether with reporting income and expenses along with depreciation is itemized on Schedule E with limited personal and family use.
Johnson vs. Commissioner of Revenue, 2014 WL 2965410 (Minn. Tax Ct., June 20, 2014) is a Minnesota state tax court case on whether the taxpayer’s replacement property was acquired for the proper 1031 intent. The fact pattern was that soon after the condominium was acquired their son moved in, paying a $300 rental fee; however, no further payments were made. The son had no other residence. The taxpayer claimed a moderate rental loss on their federal return but in following years did not claim any rental revenue or expenses nor make any effort to rent to another party. The taxpayers claimed they had not used the property for personal use, consequently qualifying for a 1031 tax deferred exchange. The tax court disagreed, citing the IRC Section 280A(d)(2)(A) exclusion of treating residential property as investment property if used as a dwelling unit by a family member. Even though the taxpayer’s intent was to hold as an investment property, the tax court determined that no other renter was pursued along with other circumstantial testimony including that their son did not make rental payments to support that the property was held in the productive use of a business or for investment.
Care must be given to support the proper intent. Ignorance is no excuse. If you have a question regarding your 1031 exchange, please click on the button below to ask a Certified Exchange Specialist®.
