If you want your exchange to qualify for deferral under 1031, it is not enough that the properties be of like kind. (With real estate "like kind" is not much of a hurdle. As long as you stay in the United States, you would have to work to come up with a real estate interest that was not of like kind to another real estate interest). The other important requirement is that both your relinquished and target properties have to be held for use in a trade or business or held for investment. Next question. How long ? That is what Patrick and Jill Reesink were recently in Tax Court about.
Patrick Reesink owned an undivided interest in an apartment building with his brother. They did not get along all that well, which actually created another aspect of the case , a tort claim that Mr. Reesink unsuccessfully tried to exclude, which I am not getting into. The building was sold on September 23, 2005 and Patrick structured his share as a like kind exchange. Here is what happened next:
On November 4, 2005, petitioners purchased the Laurel Lane property for $649,900 as well as an undeveloped adjacent lot for $30,000. They received a residential loan of $138,200 from Home Loans USA to help finance the purchase of the Laurel Lane property, subject to a deed of trust. A box was checked on the loan application indicating that the Laurel Lane property was purchased for investment purposes. Petitioners paid $27,456 of settlement charges associated with the sale of the Laurel Lane property. The seller financed $27,000 of the adjacent lot's selling price.
Petitioners posted flyers throughout Guerneville advertising the Laurel Lane property for rent but did not advertise in the newspaper. Mr. Reesink's other brother, Richard Reesink, changed light fixtures and installed security lighting at the Laurel Lane property. He saw "for rent" signs at the Laurel Lane property every time he was there, which he estimated to be at least 10 or 12 times.
On advice from Mr. Millar, petitioners attempted to rent the Laurel Lane property for $3,000 per month. On two different occasions, potential renters Tabatha Howell and Scott Wright visited the Laurel Lane property. However, both parties ultimately notified petitioners by letter that they had decided not to rent the Laurel Lane property because the monthly rent was out of their price range. Petitioners never lowered their monthly asking price, nor did they ever find tenants for the Laurel Lane property.
Besides the "rental property" at Laurel Lane, the Reesinks had a principal residence and a trailer located near Mr. Reesink's former job. (He was disabled). Carrying three properties became a strain. So in 2006, they decided to sell their residence and move into the Laurel Lane property. Their move into the Laurel Lane property was roughly eight months after its acquisition. As noted above, it was never rented. The IRS wanted to blow up the exchange taking the view that the Reesinks intended to use the Laurel Lane property personally from the time that they acquired it.
On the exchange issue the Court went with the Reesinks.
Respondent [IRS] argues that petitioners' actions surrounding the purchase of the Laurel Lane property were so unreasonable that they could not have intended to hold the Laurel Lane property for investment purposes and that they really purchased the Laurel Lane property to use as their residence. Respondent supports his argument by emphasizing that petitioners had a "healthy balance sheet" and by pointing to all of the actions they could have taken. In 2005 petitioners' decision to purchase the Laurel Lane property may not have been financially sound, but it was not unreasonable for them to believe they could supplement their diminishing wages with rental proceeds.
Moreover, we do not determine petitioners' intent on the basis of their financial position because we find the trial testimony of Mrs. Reesink, Richard Reesink, and Scott Wright to be credible. Mrs. Reesink testified that she never discussed moving to Guerneville until after the exchange had been completed, and petitioners believed they were in a financial predicament. Richard Reesink testified that petitioners were having a hard time renting the Laurel Lane property and that he was surprised they sold their primary residence. Finally, Scott Wright testified that he visited the Laurel Lane property with the intention of renting it.
Perhaps the strongest indicator of petitioners' intent at the time of the exchange comes from respondent's witness--Michael Reesink. He testified that Mr. Reesink had told him on several occasions that petitioners planned to sell their personal residence and move to Guerneville once their children were out of high school. Mr. Reesink's oldest son was born in March 1991, the apartment building was sold September 23, 2005, and the Laurel Lane property was purchased November 4, 2005. Therefore, at all times during the exchange process petitioners' eldest son was only 14 years old. Moreover, he was only 15 years old when petitioners moved into the Laurel lane property-- he was still in high school throughout all of the events surrounding the like-kind exchange. Michael Reesink's testimony supports the proposition that at the time of the exchange, petitioners held the Laurel Lane property with investment intent. (Michael was the brother that Patrick sued.)
I can really see why the IRS went after this transaction. The Reesinks owned a principal residence and a rental property. (Although not mentioned in the case, most, if not all, of the gain from the residence sale must have been excluded as gain from the sale of a principal residence). In less than a year, they have a pile of cash and a different principal residence recognizing little or no gain. Better to be lucky than good.
I am ethically proscribed from giving advice that exploits the audit selection process of a taxing authority, so I want you to take what I have to say next as a mere observation. I would have felt a lot better about this transaction, if they had held the Laurel Lane property for at least one full return year before converting it to personal use. In this case that would have meant not converting it until January 2007. They won anyway, though, which emphasizes the point that "held for use in a trade or business or for investment" means the purpose at the time of the exchange. There is not a bright line test for how long you have to wait before changing your mind.