By Pam Michaels: Substantiating investment intent in a §1031 exchange

A taxpayer's intent to hold both the relinquished property and replacement property for investment or for use in a trade or business is a requirement for any exchange transaction qualifying for tax deferral under Internal Revenue Code Section 1031. The IRS and federal courts may examine all of the facts and circumstances surrounding the transaction to determine the taxpayer's true intent at the time of the exchange. If those facts and circumstances are not consistent with the requisite investment intent, the exchange may not qualify for tax deferral. Listed below are some factors the IRS may review to determine whether or not the intent was to hold the property for investment. The burden of substantiating the investment intent is the responsibility of the taxpayer and the items below are not an exhaustive list but provide useful indicators in determining the taxpayer's intent: * The purpose for which the property was initially acquired; * The purpose for which the property was subsequently held; * The purpose for which the property was being held at the time of sale; * The extent of advertising, promotion of other active efforts used in soliciting buyers for the sale of the property; * The listing of property with brokers; * The extent to which improvements, if any, were made to the property; * The frequency, number and continuity of sales; * The extent and nature of the transaction; * The ordinary course of business of the taxpayer. Real estate held as "stock in trade or other property primarily for sale" is excluded from the tax deferral benefits of IRC Section 1031. Stock in trade describes property which is included in the inventory of a dealer and is held for sale to customers in the ordinary course of business. The gain on the sale of this property is taxed as ordinary income. A recent Tax Court case illustrates the consequences of failing to substantiate investment intent. In Goolsby v. commissioner (April 1, 2010); T.C. Memo. 2010-64, taxpayers exchanged a relinquished property in California for two replacement properties located in Georgia. Two months after the exchange was completed, the taxpayers moved into one of the replacement properties (the Pebble Beach property) and used it as their personal residence. The IRS took the position that the Pebble Beach 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). The Tax Court rejected the taxpayers' argument that certain other facts demonstrated that they intended to rent the property when they acquired it and decided later to move into the property. 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. In rejecting the taxpayers' argument, the Tax Court found that the Goolsbys: * Conditioned the purchase of the Pebble Beach property on the sale of their former primary residence in California; * Asked their qualified intermediary (QI) about converting an investment property into a residence before the exchange was completed; * Failed to research whether the covenants of the homeowner's association would permit the Pebble Beach property to be used as a rental and generally did little research on the rental market; * Placed a rental advertisement in a small neighborhood newspaper for only two months and made no other efforts to rent the property; * Began preparations to finish the basement of the Pebble Beach property within two weeks after purchasing the property. Note that any non-privileged discussions evidencing a contrary intent before, during, or after the exchange are fair game for the IRS, even the taxpayer's discussions with a qualified intermediary. 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, 81 T.C. 782, 804 (1983), affd. 760 F.2d 1039 (9th Cir. 1985), Click v. Commissioner, 78 T.C. 225, 231 (1982) and Moore v. Commissioner, T.C. Memo. 2007-134. Pamela Michaels, Esq. is an attorney and vice president of Asset Preservation, Inc., Manhattan, N.Y. 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.