Lisa Lambert, Esq. (1031 Exchange Expert)

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Taxpayers use Internal Revenue Code (IRC) §1031 tax deferred exchanges to defer paying capital gain taxes on the sale of property held for investment or used in a trade or business. Many tax and legal advisors believe it is possible to perform an exchange on a vacation property, provided the personal use is incidental and the taxpayer can substantiate that the primary purpose was holding the property for investment, not personal use.

TAX GUIDANCE FROM COURT DECISIONS AND A PLR

In Barry E. Moore v. Commissioner (2007), the tax court determined that the taxpayer's primary intent for holding both their relinquished and replacement vacation property was personal use, not investment. See Asset Preservation's handout entitled, "Vacation Home Exchanges - Barry E. Moore v. Comm.", for a more detailed analysis and review of this significant vacation home decision.

In the tax court case, Rivera v. Commissioner (2004), the tax court noted that, "...the term ‘income' is not confined to recurring income but may also apply to gains from the disposition of property." In this case, the court found the taxpayers held the property for investment purposes because they had purchased it with the expectation it would increase in value. The court referenced Section 1.183-2(b) of the Income Tax Regulations which outlines nine factors indicating whether or not a taxpayer is involved in a venture that is intended to produce a profit.

Another reference for tax guidance on vacation home exchanges comes from Private Letter Ruling (PLR) 8103117 which states "...the house and lot you acquire in this trade will be held for the same purposes as the properties exchanged: to provide for personal enjoyment and to make a sound real estate investment." Although a PLR only applies to the facts and circumstances in a specific situation, in this instance, some limited personal enjoyment of a property did not prevent a taxpayer from benefiting from a §1031 exchange. In this PLR, however, it is important to note that the personal use was minimal on the relinquished property in the years before the taxpayers sold this property and entered into a §1031 exchange.

ISSUES TO CONSIDER IN VACATION HOME EXCHANGES

Any taxpayer contemplating an exchange of a property in a vacation or resort destination area should be able to substantiate that their primary objective was investment, not personal use. This may be supported with documentation establishing their investment intent at the time of purchase (or conversion, if a second home is converted to a rental vacation property at a later date), through efforts to rent the property, by rental income and by treating the property as investment, as opposed to residence, on the tax return. Always consult with a knowledgeable tax and/or legal advisor in any §1031 tax deferred exchange.

The information provided is for educational purposes only. It is not legal or tax advice. Accordingly, the taxpayer should review the details of the specific transaction with taxpayer's own legal or tax advisor.

SECTION 1.1031(k)-1

Section 1.1031(k)-1: Treatment of Deferred Exchanges states that "the identification period begins on the date the taxpayer transfers relinquished property and ends at midnight on the 45th day thereafter." Later in this subsection, the manner of identifying replacement property is specifically stated as: "Replacement property is identified only if it is designated as replacement property in a written document signed by the taxpayer and hand delivered, telecopied, or otherwise sent before the end of the identification period to either - (i) The person obligated to transfer the replacement property to the taxpayer (regardless of whether that person is a disqualified person as defined in paragraph (k) of this section); or (ii) Any other person involved in the exchange other than the taxpayer or a disqualified person (as defined in paragraph (k) of this section). Examples of persons involved in the exchange include any of the parties to the exchange, an intermediary, an escrow agent, and a title company."

FORM 8824 - LIKE-KIND EXCHANGES

On Form 8824, Part I, Item #5, the IRS asks for the following information: "Date like-kind property you received was identified by written notice to another party (see instructions for 45-day written notice requirement) (month, day, and year)." As both the code and Form 8824 indicate, there is no leeway whatsoever in properly identifying replacement property in an exchange. Identification must be made in writing and within 45 calendar days from the relinquished property closing. Any attempt to try to circumvent these rules is considered tax fraud and could result in significant negative consequences.

WHAT WERE THEY THINKING?

In the Tax Court case, Dobrich vs. Commissioner (October 20, 1997), the taxpayers committed tax fraud by falsifying the date property was identified. The taxpayers misrepresented to the IRS that they had properly identified replacement property by back-dating documents in an attempt to reflect that an "oral identification" had been made. They tried to fabricate their identification and created false documents to attempt to substantiate their claim. The Court found evidence of the Dobrich's intent to defraud and ruled that they were liable for a Section 6663 fraud penalty. In addition, the taxpayer plead guilty to a criminal charge of causing the delivery of false documents to the IRS.

Ultimately, the taxpayers were liable for the $2.2 million in capital gain taxes they were attempting to defer....plus an additional 75% fraud penalty of an additional $1.6 million!

The bottom line: Every taxpayer should make sure that they properly identify replacement property within the 45 calendar day identification timeline - period.

BE PROACTIVE!!

There isn't any reason that a taxpayer needs to wait until the relinquished property sale has closed before beginning to look for suitable replacement property. This effectively gives the taxpayer more than 45 days to find replacement property. Of course, the property must be properly identified before it qualifies a replacement property for that taxpayer for that exchange.

The information provided is for educational purposes only. It is not legal or tax advice. Accordingly, the taxpayer should review the details of the specific transaction with taxpayer's own legal or tax advisor.

ONE SALE - TWICE THE TAX BREAKS!

Sellers of farms and ranches are able to take advantage of two different tax code sections to minimize capital gain tax liabilities. By utilizing all the opportunities available in the tax code, many ranch and farm owners can meet their investment objectives and defer capital gain taxes! Often some of the property can qualify for tax exclusion under IRC §121 and the remainder can qualify for tax deferral under IRC §1031.

BENEFITS OF IRC SECTION 121

The 1997 Taxpayer Relief Act provided property owners significant tax advantages on the sale of a principal residence. IRC §121 allows a homeowner to exclude capital gain taxes if they meet the following requirements:

· Couples filing a joint tax return can exclude up to $500,000 of the capital gain on the sale of their principal residence, and single filers can exclude up to $250,000.

· The home must have been the primary residence of both spouses two of the last five years.

· The exclusion is available once every two years.

In addition, a property owner can obtain tax exclusion on the sale of vacant land, under T.D. 9030, if:

· The vacant land is adjacent to the land containing the taxpayer's principal residence;

· The property owner owned and used the vacant land as part of their principal residence;

· The property owner sells or exchanges the principal residence that meets the requirements of §121 within 2 years before or 2 years after the date of the sale or exchange of the vacant land;

· The requirements of §121 have otherwise been met.

WHAT IS AN IRC SECTION 1031 EXCHANGE?

Section 1031 of the Internal Revenue Code allows an owner of property "held for productive use in a trade or business" or "held for investment" to exchange for another "like-kind" property and defer paying capital gain taxes. Although there are some misconceptions, this does not require exchanging a ranch for another ranch since the definition of "like-kind" property is very broad. For example, a property owner can exchange out of a farm or ranch and acquire:

· Single family rental, duplex or triplex

· Apartment or commercial property

· Another farm or ranch property

· Vacation home primarily "held for investment"

WHAT IS NEEDED TO ACCOMPLISH THIS?

A good accountant or real estate attorney is often needed to determine the value of the residence portion of the transaction and the land used in the farm or ranch operation. An experienced "Qualified Intermediary" is essential to a successful exchange. Call the 1031 exchange experts at Asset Preservation to learn more!

The information provided is for educational purposes only. It is not legal or tax advice. Accordingly, the taxpayer should review the details of the specific transaction with taxpayer's own legal or tax advisor.