To qualify as a like-kind exchange, both the property the taxpayer gives up (the relinquished property) and the property the taxpayer receives (the replacement property) must be held for investment or for productive use in the taxpayer’s trade or business (Code Section 1031(a)(1); Revenue Ruling 90-34, Revenue Ruling 89-121, Magneson v. Commissioner, 81 Tax Court 767 (1983); Bolker v. Commissioner, 760 Federal 2d 1039 (9th Circuit 1985); Maloney v. Commissioner, 93 Tax Court 89 (1989)).
In Click v. Commissioner, 78 Tax Court 225 (1982), the taxpayer exchanged her farm for two residential properties, cash, and a note. On the same day, her two children and their families each moved into the residences. Approximately seven months later, the taxpayer transferred the homes by gift to her children. The Tax Court held that the exchange did not qualify for nonrecognition treatment under Code Section 1031(a) because the taxpayer did not intend to hold the property received for productive use in a trade or business or for investment.
In Revenue Ruling 75-291, the IRS examined an exchange of land and a factory used by a manufacturing corporation for land and a factory owned by another corporation that acquired the land and constructed the factory solely for the purpose of making the exchange. The IRS ruled that the exchange, as to the manufacturing corporation, qualified for nonrecognition of gain or loss under the like-kind exchange rules because the corporation used the property it transferred in its trade or business, but as to the other corporation, the IRS ruled that the exchange did not qualify under Code Section 1031 because the property the corporation transferred had not been used in its trade or business.
Similarly, in Revenue Ruling 84-121, an individual owned a parcel of unencumbered real property that he used in his trade or business and that had an adjusted basis of $50 and a value of $100. For $5, the owner granted to another individual an option to purchase real property for a price of $100. The option allowed the purchaser to pay the option price in cash or to transfer real property equal in value to the option price. The purchaser exercised the option before the expiration of the option period, but instead of paying $100 in cash, he purchased for $100 another parcel of real property with a fair market value of $100 and immediately transferred that property to the owner of the property he was purchasing. At the time the option was exercised, the value of the real property subject to the option had increased from $100 to $150. The owner used the property acquired from the purchaser in his trade or business. The IRS ruled that, the exchange of real property qualified as a like-kind exchange with respect to the owner of the property because both the real property he transferred to the purchaser and the real property he received were used in his trade or business. The exchange, however, did not qualify as a like-kind exchange with respect to the purchaser because the property he acquired acquired before the exchange was not used in his trade or business or held for investment. Thus, when the purchaser transferred to the owner the property that he had acquired in order to exercise the option, the purchaser disposed of that property in a taxable transaction because he had not met the requirements of Code Section 1031.
In Adams v. Commissioner, Tax Court Memo. 2013-7 (2013), the Tax Court held that, even though replacement property was occupied by the taxpayer’s son, the property was still investment property and qualified for like-kind exchange treatment. The court rejected the IRS’s argument that the sale of a home and the purchase of another home by the taxpayer did not qualify for like-kind exchange treatment because the taxpayer acquired the house for personal purposes with the intention of letting his son and family live there at below market rent.
For exchanges completed before 2018, examples of property that may qualify include machinery, buildings, land, trucks, and rental houses. However, the following types of property are specifically excluded from Code Section 1031 treatment:
(1) property held primarily for sale;
(2) inventories;
(3) stocks, bonds or notes;
(4) other securities or evidences of indebtedness;
(5) interests in a partnership (although see below for rules applicable to exchanges involving partnerships with a Code Section 761(a) election that are completed after 2017);
(6) certificates of trusts or beneficial interest; and
(7) choses in action (pre-TCJA Code Section 1031(a)(2)).
Thus, for example, if a realtor or developer buys (or builds) and resells homes regularly, the IRS could construe this activity as a business and the homes would be considered inventory and not eligible for the like-kind exchange rules. The same would be true with equipment held for both rental and sale, where the income is overwhelmingly generated from sales rather than rentals (CCA 201025049).
A taxpayer’s (Realtor, Broker, or Real Estate Professional) intent to hold a property for productive use in a trade or business or for investment is a question of fact that must be determined at the time of the exchange (Bolker v. Commissioner, 81 Tax Court 782 (1983), Affirmed, 760 Federal 2d 1039 (9th Circuit 1985)). Taxpayers bear the burden of proving that they had the requisite investment intent (Click v. Commissioner, 78 Tax Court 225 (1982)).
The Tax Court has held that investment intent must be the taxpayer’s primary motivation for holding the exchanged property in order for the property to qualify as held for investment for purposes of Code Section 1031. The use of property solely as a personal residence is antithetical to its being held for investment (Moore v. Commissioner, Tax Court Memo. 2007-134; Starker v. United States, 602 Federal 2d 1341 (9th Circuit 1979)).
In Goolsby v. Commissioner, Tax Court Memo. 2010-64, the taxpayers made the purchase of replacement property contingent on the sale of their former personal residence and sought advice regarding whether they could move into the replacement property if renters could not be found. The taxpayers’ only rental efforts consisted of placing a single advertisement in a neighborhood newspaper. Within two weeks of purchasing the property, the taxpayers began preparations to refinish the basement. The taxpayers subsequently moved into the replacement property within two months of acquiring it. The Tax Court found the taxpayers did not hold the replacement property with investment intent at the time of the exchange.
In Moore v. Commissioner, Tax Court Memo. 2007-134, the Tax Court held that the taxpayers’ sale of one vacation property followed by the purchase of another vacation property did not qualify as a Code Section 1031 like-kind exchange because, at the time of the exchange, the taxpayers’ primary motivation for holding the properties was not for investment. The taxpayers used both vacation properties exclusively for recreational purposes–they never attempted to rent either property. According to the Tax Court, the mere expectation that the properties would increase in value is not enough to show the properties were held primarily with investment intent.
However, there was a different result in Reesink v. Commissioner, Tax Court Memo. 2012-118, where the taxpayers chose to sell their primary residence and move into the replacement property they had purchased in order to alleviate liquidity problems. Before the move, the taxpayers placed fliers throughout the area, showed the property to potential renters, and waited almost eight months before moving in. Unlike the taxpayers in Goolsby, who made the purchase of the replacement property contingent on the sale of their personal residence, the taxpayers in Reesink decided to sell their personal residence almost six months after purchasing the replacement property. And unlike the taxpayers in Moore, the taxpayers in Reesink made attempts to rent the replacement property and refrained from using it for recreational purposes before moving in. The Tax Court rejected IRS arguments that the taxpayers had a “healthy balance sheet” and rejected IRS theories as to all of the actions the taxpayers could have taken. The taxpayers had a multitude of current liabilities, including their children’s tuition, child support, adoption expenses, three mortgage payments, a home equity line of credit, and other real property expenses. In addition, most of their assets were invested in real property.
Practice Tip: A partnership interest does not qualify for like-kind exchange treatment. However, a partnership may trade real estate in a like-kind exchange transaction and the partnership may distribute the assets tax free to individual partners before the exchange, and then the partners may do the like-kind exchange. Effective for exchanges completed after 2017, Code Section 1031(e) provides that, an interest in a partnership which has in effect a valid election under Code Section 761(a) to be excluded from the application of all of subchapter K is treated as an interest in each of the assets of such partnership and not as an interest in a partnership. Stock in a corporation, including an S corporation, does not qualify for like kind exchange treatment, but the corporation itself may exchange property under Code Section 1031. The distribution of assets to S shareholders won’t work because this is a taxable event in an S corporation.
Because both the relinquished property and replacement property must be held for productive use in a trade or business or for investment, property acquired for immediate resale does not qualify for like-kind exchange treatment. Neither does property held for personal purposes.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
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(Updated 03/21/2021 08:05)