1031 Tax Update

 

Goolsby v. Commissioner (April 1, 2010); T.C. Memo. 2010-64

The Tax Court held that property acquired by 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 taxpayers signed a purchase agreement to acquire a single family property in Georgia (the Pebble Beach property). The purchase agreement was contingent upon sale of taxpayers' personal residence in California. In February 2003 taxpayers sold their principal residence in California and began living with their in-laws in Georgia. In March 2003 taxpayers sold rental property located in California and used a QI to structure an exchange. Taxpayers purchased the Pebble Beach property as replacement property. 

The court ruled that 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 exchange, and therefore it was not valid replacement property. The court first noted that taxpayers moved into the Pebble Beach property two months after acquiring it. Further, they did not move into it temporarily until renters could be found. Their efforts to rent the Pebble Beach property were minimal. They merely placed an advertisement in a neighborhood newspaper for a few months, and no further efforts were made 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 construction, within two weeks of purchase. 

The court surmised that taxpayers were contemplating use of the Pebble Beach property as a personal residence before the exchange. It noted that taxpayers made purchase of the Pebble Beach property contingent upon sale of their personal residence in California. They sought advice from the QI regarding whether they could move into the property if renters could not be found. Taxpayers did not research whether covenants of the homeowners association would allow for rental of the Pebble Beach property before the exchange. They also did not research rental opportunities in the area prior to the exchange.

Taxpayers contended that purchase of the Pebble Beach property was not extravagant when compared to costs of California properties. The court responded that the relative values of properties were irrelevant. 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. The court dismissed this argument as non-persuasive. 

The court also found the taxpayers liable for the accuracy related penalty due to a substantial understatement of tax. 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 highlights 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. The taxpayers asked the QI if they could move into the property if renters could not be found. 


Provided by the Federation of Exchange Accommodators.