Entering into a Section 1031 Exchange instead of a traditional sale is a common tactic used by taxpayers to try and limit capital gains tax exposure. Under a Section 1031 Exchange, like-kind property held for productive use in trade or business or for investment is exchanged instead of sold and any realized gain may be deferred. While some like-kind exchanges are relatively straight forward and uncomplicated, others are not so simple. When a taxpayer combines exclusions, as was the case in the recent Tax Court Memo 2013-28, Yates v. Commissioner of Internal Revenue Service it can further complicate matters.
In Yates, the Tax Court argued that taxpayer had artificially manipulated the fair market value of property included in the exchange in order to maximize exclusions and that one of the properties that was part of the 1031 Exchange did not qualify for 1031 Exchange treatment because it was held primarily for personal use.
Proper Intent
In a Section 1031 Exchange, both the property relinquished and the replacement property must be held for productive use in trade or business or for investment to reap the full benefits of deferral of capital gains on the realized gain. In Yates, the taxpayer owned two properties. One property was used for personal and business (Lakeview) and the other property was used to operate a restaurant (Harper), both of which he wished to sell. Eventually, taxpayer negotiated a deal with a buyer to relinquish both properties in a 1031 Exchange deal after making the relinquishment of the Harper property contingent upon inclusion of the Lakeview property. The IRS contended that the allocation of fair market values for the individual properties relinquished in the transaction were not indeed fair market values. The total purchase price was $2.15 million with $895,000 allocated to the Harper property, $505,000 to the restaurant to cease doing business, and $750,000 for the Lakeview property. The IRS argued, among other things, that the Harper property was worth much more and the Lakeview much less. At trial, the IRS offered evidence that:
- The Harper property had been previously listed for $2.5 and $3.1 million.
- An appraisal of the Harper property came in at $1.8 million one year prior to the exchange
- The Lakeview property was sold, nine months after the exchange for $310,000 after the purchaser spent an additional $10,000-$15,000 to make repairs and renovations.
Taxpayer also made use of the Section 121 Exclusions which allows a taxpayer to exclude from computation for purpose of capital gains taxes up to $500,000 (married filing jointly) when a residence is sold if the taxpayer lived in the residence for at least the previous two years. The IRS argued that taxpayer manipulated the values in order to take advantage of both the Section 121 exclusion and the Section 1031 deferral.
Finally, taxpayer argued that his replacement property (Memorial Drive) counted as business or investment property based almost exclusively on a request in the contract that the seller apply to the town for a permit to operate the property as a bed and breakfast. There was no evidence admitted at trial that the seller ever did this, the sale was not conditioned on permission, and taxpayer moved in four days after the transaction was complete and used the property solely as a residence.
The Tax Court first decided the issue of fair market value. Although there was some evidence that the values were manipulated, the court did not find enough evidence to conclude that the IRS met its burden in challenging the figures. The court noted:
”In determining the fair market value of a property, we endeavor to ascertain the price that a willing buyer would pay a willing seller, both persons having reasonable knowledge of all relevant facts and neither person being under a compulsion to buy or to sell. See United States v. Cartwright, 411 U.S. 546, 551 (1973) (applying the standard set forth in section 20.2031-1(b), Estate Tax Regs.).”
Given that the transaction in question all occurred during the height and fall of the real estate market in the area, it is at least plausible that the figures truly represented a meeting of the minds between the two parties. Therefore, taxpayer’s fair market values used to compute any capital gains liability were allowed to stand.
On the other hand, the Tax Court did find that the taxpayer had failed to meet his burden in showing that the replacement property was indeed used for business or investment purposes noting that the “provision (regarding the bed and breakfast) served as nothing more than a trivial addition inserted in the contract for the purpose of securing petitioners’ desired non-recognition treatment of the exchange”
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