This is one of the most common questions asked of a qualified intermediary.
The answer: Qualifying property under §1031 must be held by the taxpayer for “productive use in a trade or business, or for investment.” The determination of whether property is held for productive use in a trade or business or for investment is made as of the time of the exchange. If the “intent” of the taxpayer is to convert the replacement property to his/her personal residence, the tax is due and payable upon conversion.
However, there is the possibility that the holding purpose may change while the taxpayer owns the property. As an example, if the property is being held as a principal residence that later becomes rental property it may qualify as investment property. Moreover, property held as an investment may become the taxpayer’s personal residence. It is important to remember that the taxpayer’s intent at the time of the exchange is critical.
Consider this scenario: A taxpayer completes a §1031 exchange and their replacement property was a single-family rental. What would happen if a fire destroys their principal residence, forcing them to convert the replacement property to their personal residence, and it all happens in the same tax year? It is fairly certain that the taxpayer did not intend to have their house burn down, forcing them to move into the replacement property. In the event of an audit, the IRS will look at many factors, including, but not limited to; how long the original investment property was held, whether the taxpayer intends to rebuild what was their principle residence and if the intent for the replacement property is to have it once again become an investment property. Most commentators agree that the scenario described would most likely survive the audit.
It is important to remember that the longer taxpayer holds the property before or after the exchange, the more likely it is that the property was held by the taxpayer for “productive use in a trade or business or for investment.” Unfortunately, the IRS has not issued a clear rule in this area.
The more evidence there is showing the property is an investment property the better. However, there is no requirement that the property actually be used in a trade or business or for investment, or that it actually generates income. As long as the taxpayer intends to hold the property for “productive use in a trade or business, or for investment” at the time of the exchange, the holding purpose requirement is satisfied.
While the answer may be somewhat elusive, remember intent is key. It is also important to think about the length of time the investment property is held, and, as with anything else, maintain proper documentation as to the property’s intended use as a trade or business or for investment.
Taxpayers should always seek advice on any 1031 exchange transaction from a qualified attorney or accountant.
IRC Section 1031 allows taxpayers to defer the gain on the disposition of business or investment real estate, if that real estate is replaced with like-kind real estate, within specific timeframes. Consult your tax or legal advisor for additional information on the requirements and limitations of such exchanges. Wilmington Trust 1031 Exchange LLC is a wholly owned subsidiary of Wilmington Trust, N.A. *Wilmington Trust 1031 Exchange LLC does not provide tax or legal advice to clients. Wilmington Trust does not provide tax, legal, or accounting advice. Please consult professionals in those areas before making any decisions.