Good Intentions: The True Clue for the IRS

Posted by Lucas Ecklund-Baker | Wed, Feb 28, 2024

The 1031 exchange was set up, the apartment building has sold, and the rental cabin you've just closed on is in an ideal location. You are determined to have it ready for the winter ski season. You've done your 1031 exchange homework, talked with your tax advisor and your Exchange Team at 1031 CORP., and completed the exchange within the 180-Day Exchange Period window. But there's a problem - the replacement property suddenly cannot be rented! Without the ability to rent the property, you want to sell!  


You're out of luck because short-term holding periods do not qualify for a 1031 exchange. Right? In this case, maybe not.


While Section 1031 is chockful of rules that must be followed in a 1031 exchange, the regulations do not provide much guidance on the length of time a property must be held for investment before it qualifies for 1031 treatment. A key determinant of the validity of a 1031 exchange is the Exchanger’s intent at the time of the exchange.


A Viable Attempt at a Successful Exchange


The Exchanger completed an exchange and acquired the lakefront cabin in a ski resort community in early summer. The property had one owner who held the cabin for over three decades without any updates. Before he even closed on his replacement property, the Exchanger spoke with several local real estate professionals about the local rental market and to determine what improvements would be necessary to help maximize his rental income potential. He also inquired about their leasing services. The Exchanger worked with a local lender to borrow the money for the improvements and disclosed the property would be a rental. He used the following months to complete substantial improvements to the property, including a large deck and dock on the lake behind the house to make the property available for rental year-round. During the six months of renovations, the homeowners' association changed the by-laws and prohibited rentals. While some investor homeowners banned together and retained an attorney to sue the HOA to block the change, the Exchanger didn't want to keep the property sitting without rental income for an undetermined period. He financed the renovations and needs the income to cover the mortgage payments.


Because the Exchanger acquired the replacement property in good faith, has continued to demonstrate intent to hold the property for investment, and will be exchanging to purchase another property—indeed for income—his tax advisor feels the owner's intent is clear and confident their position can be defended. A few ways intent was demonstrated include the work with the real estate professional, obtaining an investment property loan, and the holding periods of the first relinquished property and the future replacement property. Intent is more important than the length of the holding period.


An Attempt at Tax Fraud 


The reverse is true, as well. In Goolsby v. Commission, TC Memo 2010-64, the tax court determined that, after claiming a 1031 exchange and posting ads to rent, Goolsby had no intent to rent one of two replacement properties he acquired—and always planned to use it as a personal residence. 


Goolsby sold his primary residence in Oakland, California, and, having moved across the country to Fayetteville, Georgia, had begun living with his in-laws. At the same time, he sold his relinquished investment property, held for fifteen years, in a 1031 exchange. He then acquired two new rentals—one on Pebble Beach and another further inland, in Meadowbrook.  


He began renting the Meadowbrook property immediately. However, after placing one advertisement in the neighborhood newspaper offering the Pebble Beach property for rent, the owner obtained permits and began renovations within two weeks of the purchase. He failed to inquire whether the homeowners' association allowed rentals, failed to research rental opportunities in the Pebble Beach neighborhood, and asked the QI how long they would need to hold the property before moving in. The agreement for Pebble Beach property was contingent on the sale of Goolsby's primary residence. 


The IRS questioned Goolsby's intent to hold the Pebble Beach property for investment at the time of the exchange. In court, after reviewing the evidence, the judge ruled that the owner lacked the intent to hold the property for investment. 


The tax court ruled the inland rental qualified, but the beachfront property was ineligible for 1031 treatment, hinging on intent, and Goolsby was assessed the tax, interest, and penalties. 


In Defense of Your Exchange 


Compliance with the spirit of the regulations is essential in a 1031 tax-deferred exchange. If the IRS challenges your exchange, there are ways to show your intent. A determination of deficiency by the IRS is presumed correct, and the burden of proving it is incorrect falls on the Exchanger, so facts are imperative. 


The best way to protect yourself in the event of an audit is to have good documentation supporting your efforts to hold the property for business use or investment. Some ways investors can document their intent include tracking the time and money spent maintaining and improving the property by you or outside contractors, advertising the property for rent, and negotiating leases. Of course, exchange documentation is also essential, so 1031 CORP. will provide copies of all pertinent exchange documentation and a detailed summary of all funds in and out of your exchange account.


1031 CORP. cannot provide tax or legal advice, but our knowledgeable Exchange Team is here to educate Exchangers and work with their advisors.

Topics: 1031 exchange rules, Live

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