Intent is Key to a Successful Exchange
Tax Court Also Questions Whether Taxpayer Meets 750 Hours Needed to Claim Passive Losses
A recent tax case involved a situation that a Qualified Intermediary (QI) is frequently asked about. “How long must I wait before moving into my replacement property?” While a QI is not permitted to give its clients tax or legal advice, it certainly can share this case and others with the client and his/her professional advisors to help empower them to make the best decision in his/her individual situation.
In Goolsby v. Commissioner (April 1, 2010), T.C. Memo. 2010-64, the Tax Court found that Mr. and Mrs. Goolsby had no intent to rent one of the two replacement properties acquired and their sole objective was to use it as their primary residence. Here are the facts of this case:
- Taxpayer owned primary residence in Castro Valley, CA.
- In October 2002, Taxpayer signed agreement to purchase a property in Fayetteville, GA (Pebble Beach). Agreement was contingent on the sale of Taxpayer’s Castro Valley, CA home.
- On February 11 2003, Taxpayer sold the Castro Valley primary residence and relocated to Fayetteville, GA where they began living with their in-laws.
- Taxpayer purchased an investment property in Oakland, CA in 1990 for $270,000. On March 3, 2003, Taxpayer sold Oakland property for $605,000 through a 1031 exchange.
- Taxpayer identified and acquired the Fayetteville, GA (Pebble Beach) property as well as a second Fayetteville (Meadowbrook) property.
- Taxpayer attempted to rent the Pebble Beach property by placing an advertisement in a neighborhood newsletter, Fayetteville Neighbor.
- Unrelated to the 1031 exchange, Mrs. Goolsby served as the primary caretaker of Taxpayer’s several rental properties but failed to keep contemporaneous logs of the time she spent managing the properties. Taxpayer reported she spent the required 750 hours managing the properties to meet the requirements for being a real estate professional (Section 469(c)(7)(B) and claim all of the passive losses. She did create “activity” logs after their 2003 and 2004 federal returns were examined by IRS.
- Taxpayer claimed passive losses of $109,919 on their 2003 return and $31,857 in 2004 related to their rental properties.
- In January 2007, IRS sent Taxpayer a notice of tax deficiency and Taxpayer filed a petition with the Tax Court for redetermination of the deficiencies.
A determination of deficiency by the Commissioner is presumed correct and the burden of proving it is incorrect falls on the taxpayer. Following is the summary of the opinion of the Court related to the 1031 exchange:
- There was no question as to whether the transaction qualified as an exchange. The Oakland property and new Meadowbrook property were held for investment.
- The Court questioned Taxpayer’s intent to hold the Pebble Beach for investment at the time of the exchange and reviewing the evidence ruled that Taxpayer lacked the requisite intent to hold the property for investment.
- Taxpayer also asked QI how long they must wait before moving into the replacement property.
- Within two weeks after acquiring the Pebble Beach, Taxpayer hired a contractor to finish the basement of the property and began obtaining building permits.
- The Taxpayer failed to inquire whether or not the homeowners association permitted the rental of the Pebble Beach property.
- Taxpayer failed to research rental opportunities in the area of the Pebble Beach property.
- Agreement for Pebble Beach property was contingent on the sale of Taxpayer’s primary residence in Castro Valley, CA.
The Court also looked at whether the losses from Taxpayer’s rental properties constituted passive activity losses for their 2003 and 2004 tax years. Upon review of the 2003 “activity logs” prepared by Mrs. Goolsby years after the tax years, the Court ruled they were not credible or persuasive and Taxpayer failed to meet the required 750 hours. The activity logs for 2004 were for less than 750 hours. The losses for both tax years were passive activity losses and in the absence of any income from passive activities are not allowable as deductions from the calculation of taxable income.
The Court ruled that Taxpayer is liable for all accuracy related penalties for 2003 and 2004 tax years and a recalculation of Taxpayer’s itemized deductions, standard deduction and exemptions is required.
At first glance this tax case appears to provide further guidance on 1031 holding periods when one wishes to convert a replacement property into a personal use property either as a primary residence or a vacation home. For many years, advisors have suggested holding a replacement property as a rental property for one to two years before any conversion to personal use. This case involves a taxpayer who clearly intended to use one of the replacement properties as their primary residence and it is no surprised the property did not qualify.
However, the Court’s questioning of the taxpayer’s claim to have spent 750 hours providing real estate services should be an eye opener for anyone claiming to have the 750 hours and does not keep good records of their activity. One of the requirements to have no limits on passive activity losses is for real estate professional to spend 750 hours in the real estate profession which can include managing rental properties. Some of the ways to document your time include an identification of services performed over a period of time and the approximate number of hours performing such services during such period based on appointment books, calendars and narrative summaries.
Note in this tax case, the taxpayer received the notice for additional taxes three and four years after filing. Good records are not only imperative but the lack of them could be very costly.
This case drives home the point that intent is always the key to a successful exchange and often times is much more important than any holding period.