If you are a rental property owner or landlord, you are not allowed to exchange rental property. The Tax Court held that property acquired by the taxpayers in a Section 1031 exchange did not qualify as replacement property when the taxpayers moved into the property two months after acquiring it. Taxpayers were also held liable for the accuracy-related penalty.
In October, 2002, the taxpayers signed a purchase agreement to purchase a single family residence in Georgia (the Pebble Beach property). The purchase agreement was contingent upon the sale of the taxpayers’ personal residence in California. On February 4, 2003, the taxpayers entered into a purchase and sale agreement to sell their rental property in California. They consulted with a QI about structuring an exchange for the Pebble Beach property, and they asked the QI if they could move into the Pebble Beach property if renters could not be found. They also sold their principal residence in California in February, 2003, and began living with their in- laws in Georgia. The sale of the rental property closed in March, 2003, and using the QI, the taxpayers purchased the Pebble Beach property as a replacement property. They moved into the Pebble Beach property two months later.
The court held that the taxpayers did not intend to hold the Pebble Beach property for productive use in a trade or business or for investment at the time of the exchange, and therefore it was not valid replacement property. The court stated that the taxpayers’ efforts to rent the Pebble Beach property were minimal. They merely placed an advertisement in a neighborhood newspaper for a few months, and made no further efforts to gain more exposure for the Pebble Beach property. Moreover, taxpayers began preparations to finish the basement of the Pebble Beach property, having a builder obtain permits for the construction, within 2 weeks of purchasing the property.
The court surmised that the taxpayers were contemplating the use of the Pebble Beach property as a personal residence before the exchange. It noted that taxpayers made the purchase of the Pebble Beach property contingent upon the sale of the California personal residence. The covenants of the homeowners association would not allow for the rental and the taxpayers did not research this before the exchange. They also did not research rental opportunities in the area before the exchange. The court also found that the taxpayers question to the QI about moving into the property further evidenced the lack of intent to hold property for investment.
Taxpayers also argued, as evidence of their intent not to reside at the Pebble Beach property, that they lived with their in-laws upon their move to Georgia, but the court dismissed this argument as non-persuasive.
The court also found the taxpayer liable for the accuracy related penalty due to a substantial understatement of tax. The taxpayers failed to present any evidence that they acted with reasonable cause and in good faith. The taxpayers did not use counsel and represented themselves.
This case points out that taxpayers should not be too quick to move into property acquired in an exchange. They should make substantial efforts to rent the property and avoid evidence of intent to use it as a residence. Note that the taxpayers asked the QI if they could move into the property if renters could not be found. You probably get this or similar questions from clients frequently. Be careful with your answers and let the client know about the fate of the Goolsbys.
Goolsby v. Commissioner (April 1, 2010); T.C. Memo. 2010-64
For further information Read: Capital Gains Tax Deferred | 1031 Exchange Tax Planning
This is a blog post for Real Estate Professionals, Investors, Landlord, Property Manager, and Property Management Companies. Rental Property Owners and Landlords: Court disallows 1031 tax exchange of rental property for residence is brought to you by SimplifyEm Pay Rent Online and Property Management Software
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