By: Pamela A. Michaels, Esq.
With prices in New York once again hitting records highs, investors are selling properties at an unsurpassed pace. In addition, with most Northeast investors being subject to capital gain tax rates in excess of 30%, more investors are turning to Section 1031 exchanges to defer capital gain taxes on the sale of their property. However, as gains are again accruing at a rapid pace and investors are again receiving unsolicited offers they do not want to refuse, it is essential that investors recognize that to qualify for a Section 1031 exchange, they must be able to demonstrate an intent to hold the property for productive use in a trade or business or for investment at the time of the exchange. See e.g., Bolker v. Commissioner 81 T. C. 782, 804 (1983), aff’d. 760 F.2d 1039 (9th Cir. 1985); Click v. Commissioner, 78 T. C. 225, 231 (1982) and that this requirement applies to both the property being sold and the property being purchased. Futhermore, it may be that the IRS defines such terms differently than the average investor.
What does not qualify as “property held for investment”? Property held primarily for resale or personal enjoyment. If one acquires property and soon thereafter sells such property, absent strong substantiation to the contrary, the IRS is likely to view such property as having been held primarily for resale. Other activities that may reflect that a property has not been held for investment include listing a property for sale, significant improvements or alterations to a property followed by immediately listing it for sale, short term holding periods and use of the property for personal enjoyment shortly after acquisition or prior to sale. Examples abound.
In Goolsby v. Commissioner (April 1, 2010); T.C. Memo. 2010-64, two months after the exchange was completed, the taxpayers converted one of the properties purchased in their exchange to their primary residence. The IRS took the position that the residence was not acquired with the requisite intent to hold for investment and failed to qualify as replacement property within the meaning of Section 1031(a). As a result, the taxpayers were liable for the capital gain taxes allocable to that portion of their exchange and also for an accuracy related penalty for understatement of tax. Other cases illustrate the importance of establishing the taxpayer’s intent to hold for investment at the time of the exchange and that the taxpayer bears the responsibility of proving it. See e.g., Bolker v. Commissioner, Click v. Commissioner, Reesink v. Commissioner, (April 23, 2012) T.C. Memo 2012-118.
These cases show the need for objective evidence of the taxpayer’s intent to hold both the relinquished and replacement property for use in a trade or business or for investment. Every taxpayer should make significant and meaningful efforts to treat a property sold or acquired in a 1031 exchange as a qualifying property held for investment. The IRS and Tax Courts will look at all of the facts and circumstances regarding an exchange transaction to ascertain the taxpayer’s intent at the time of the exchange.
Whether a taxpayer intends to hold a property for resale, or to hold for investment can be a critical issue if an exchange is challenged by the IRS. Proving such intent can be difficult. 1031 exchange investors should consult with a knowledgeable qualified intermediary and their tax/legal advisors to review their specific situation and to make sure they have sufficient documentation to establish their intent to hold for investment purposes.
Pamela Michaels is an attorney and Vice President of Asset Preservation, Inc. and can be reached at 866-317-1031 or at firstname.lastname@example.org. As a “Qualified Intermediary” as defined in the Section 1031 regulations, Asset Preservation, Inc. is not able to provide legal or tax advice. Accordingly, you should review the details of your specific transaction with your own legal or tax advisor. Copyright, 2015.