New Guidance on Converting 1031 Exchange Replacement Property to Primary Residence
Property that is the subject of an exchange must be held for a proper purpose, namely “productive use in a trade or business, or for investment.”1 The key factor in determining whether this requirement has been met is how the taxpayer intends to use the property. Intent is measured at the time the transaction takes place.2 While there is no statutory holding period, the actual holding period is reported on IRS form 8824 and often used as an indicator of intent.3
The taxpayer’s residence does not qualify as investment property under §1031.4 However, situations may change over time. What happens if the replacement property is held for investment at the time of the exchange, but the taxpayer later decides to use it as his primary residence? Will that disqualify an otherwise valid exchange? There is no bright line test. The facts and circumstances of each case must be weighed.
In the recent case of Reesink v. Commissioner5 the Taxpayers successfully defeated an IRS challenge to their exchange. Their replacement property was a single-family home, plus an undeveloped adjacent lot. They financed part of the purchase price, and the loan application indicated that the property was acquired for investment purposes.
The Taxpayers real estate agent advised them that they could rent the property for $3,000 per month. They posted flyers throughout town advertising the property for rent but did not advertise in the newspaper, a strategy they had used for other investment property they owned. On two occasions potential renters visited the property, but ultimately decided that it was out of their price range. The Taxpayers never lowered their asking price, nor did they ever find tenants. A worker who performed maintenance at the property testified that he saw “for rent” signs posted every time he was there, which he estimated to be at least 10 or 12 times.
At the beginning of 2006 the Taxpayers faced a liquidity problem. They owned three properties, all with mortgages, and also had a home equity line of credit. Coupled with the husband’s loss of income due to disability and their inability to rent the replacement property, their financial situation led to the difficult decision to sell their home.
The Taxpayers considered two options, to temporarily move in with a relative or move into the replacement property. They did not consider purchasing another property. Ultimately they moved into the replacement property and continued to live there at the time their case was decided. Approximately 7 months had passed from the time the property was acquired until they moved in.
The IRS conceded that all of the requirements of a §1031 exchange were met. The only dispute was whether the property had been held with investment intent at the time of the exchange. The Tax Court had previously ruled that to qualify under §1031, investment intent must be the taxpayer's primary motivation for holding the replacement property.6
The IRS relied on the case of Goolsby v. Commissioner of Internal Revenue7, the textbook case for what not to do. The Taxpayers in Goolsby exchanged one rental property for two replacement properties. Two months later they moved into one of the replacement properties and used it as their residence. In finding that the taxpayers did not have the requisite intent, the Court cited the following:
- The purchase of the property was contingent on the sale of the taxpayer’s former personal residence.
- The taxpayers made only minimal attempts to rent the property.
- Before purchasing the taxpayers sought advice from their Qualified Intermediary regarding whether they could move into the property if renters could not be found.
- The taxpayers began preparations to finish the basement of the property, having a builder obtain permits for the construction, within 2 weeks of the purchase.
In contrast to Goolsby, the Taxpayers in Reesink placed fliers throughout town, showed the property to potential renters, and waited almost eight months before moving in. More importantly, in Goolsby the taxpayers made the purchase of the replacement property contingent on the sale of their personal residence. In Reesink the decision to sell their personal residence came almost six months after purchasing the replacement property.
Surprisingly, the Court seemed to place the most weight on the testimony of an IRS witness, Mr. Reesink’s estranged brother. The brother testified that the Taxpayers had told him on several occasions that they planned to sell their personal residence and move once their children were out of high school. Noting that the Taxpayer’s eldest son was only 15 years old when they moved into the replacement property and was still in high school throughout all of the events surrounding the exchange, the Court found that the brother's testimony supported the proposition that the replacement property was held with investment intent at the time of the exchange.
Although the Reesink decision did not establish any quantifiable guidelines, property owners who want to convert replacement property into their residence should consider the following:
- Was there a bona fide effort to rent the replacement property? If so, make sure to document those efforts;
- What circumstances that led to the decision to move into the property? Be sure to document them, perhaps in a contemporary memo to the house file;
- How much time has passed between the acquisition of the replacement property and the conversion to a residence? The longer the better.
Please feel free to contact your local First American Exchange office if you have any questions.
1 26 USC 1031(a)(1).
2 Bolker v. Commissioner, 81 T.C. 782, 804 (1983), aff'd, 760 F.2d 1039 (9th Cir. 1985). Taxpayers bear the burden of proof. Click v. Commissioner, 78 T.C. at 231.
3 Although not relevant to this article, there are statutory holding periods for reverse exchanges, or to determine the applicability of the §121 exclusion when the replacement property is converted into a primary residence. Please contact your local First American Exchange office for more information.
4 The use of property solely as a personal residence is antithetical to its being held for investment. Starker v. United States, 602 F.2d 1341, 1350-1351 (9th Cir. 1979).
5 TC Memo 2012-118 (April 23, 2012).
6 Moore v. Commissioner, T.C. Memo. 2007-134.
7 T.C. Memo. 2010-64 (April 1, 2010).