I have a client that has owned a home in northern California for many years. He met a woman two years ago and they married and bought another home in Southern California due to her job relocating. He held on to his northern California home, but did not use as a rental. He brought me his 2005 tax information and in his paperwork, there was a 1031 exchange from a title company for his northern California home. What are the determining factors used by the IRS for investment property? Would the IRS deem his northern California home investment property rather than a personal residence being his main residence was in southern California?
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peggysioux -
Start (and probably end)
An investment is property held long-term for market appreciation. It would be reasonable for taxpayer to hold onto his previous home as an investment for a couple of years while property values continue to rise.
But is that what happened? It's even more reasonable that he used it as a second home during the transition to his new life. In what ways did he stop using it personally and treat it like an investment?
Start (and probably end) with whether he deducted mortgage interest last year. Did he have a professional property manager keep an eye on the place since obviously he was too far away to handle it himself. Did he tell his insurance and mortgage companies that it was no longer his home (it's not really fair to hold that against him, but if he did it would be a powerful argument.) How long did he hold it as an investment--don't even bother with less than a year, and be pretty suspicious with less than two years.
Also look at what he is doing with the replacement property. Although an investment can be exchanged for a rental, in this case that would look like he was making a big change in his treatment of the asset. -
Jainen, the 1031 exchange
was exchanged for another house in northern California which is currently being used as their personal residence. They also sold their house in southern California. They did claim the mortgage interest on both houses in the previous year. I don't see this exchange as being a legitimate 1031 exchange. Why would the First American Exchange Company advise my clients that they could do this exchange?? And, do I file the tax return with the sale of two properties in 2005 and disregard the 1031 exchange?peggysiouxComment
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property put to
personal use is not eligible for LKE. The 1031 is invalid, he needs to pay the taxes on the sale."A man that holds a cat by the tail learns something he can learn no other way." - Mark TwainComment
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Some 1031 info regarding "intent"
Here is some excerpts from a 1031 article. Might help you to determine the taxpayer's intent.
I have always heard 2 years is better before converting the exchange replacement property.1031 Exchange
Real estate agents who market to Baby Boomers are finding out the number one question asked by clients they work with in a §1031 Tax Deferred Exchange is: "How long must I hold the replacement property in an exchange before I convert it to my personal residence?"
The answer is: Qualifying property under §1031 must be held by the taxpayer for productive use in a trade or business or for investment. I.R.C. §1031 (a) (1). 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 their personal residence, the tax is due and payable upon conversion.
The holding purpose may change while the taxpayer owns the property. Rev. Rul. 57-244, 1957 - 1 C.B. 247. For example, property held as a principal residence that later becomes rental property may qualify as investment property. Property being held as an investment may become the taxpayers personal residence. Remember, that it is what the taxpayer's intent was at the time of the exchange.
The length of time that a taxpayer holds the property prior to or following the exchange is an important factor. The longer the 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 Service has not issued a clear rule in this area. Griffin v. Commr, 49 T.C. 253 (1967).
The more evidence showing the property is investment property the better. There is not a requirement that the property actually be used in a trade or business or for investment. As long as the taxpayer intends to hold the property for use in a trade or business or for investment at the time of the exchange, then the holding purpose requirement is satisfied. Wagensen v. Commr, 74 T.C. 653 (1980).
It can be somewhat nebulous. Keep in mind intent is key. Along with intent is length of time the investment property is held and having good documentation as to the property's intended use as a trade or business or for investment.
From another article on 1031 exchanges and transfer to personal use:
Can I immediately move into the replacement property that I acquire?
You cannot move into the The property the Exchangor is acquiring in the exchange. you acquire to replace the The original sale property, or that which is owned when the Exchangor chooses to enter into an exchange. you sold. If you do, it will not qualify as your The property the Exchangor is acquiring in the exchange.. Moving into a The property the Exchangor is acquiring in the exchange. would convert it into a principal residence which is a personal use property.
More:The intent of the Exchangor, at the time of the exchange, must be to hold the Replacement Property as investment property. The Exchangor must be able to show such investment intent for the Replacement Property.
Applying for and obtaining "owner occupied" financing defeats a showing of investment intent.
Inadvertently checking a box on the Purchase and Sale Agreement that the Buyer intends to live in the new property document doesn't help either.
Personal use of the Replacement Property by the Exchangor can defeat a showing of investment intent.
If the Exchangor intends to qualify the acquisition property under Section 1031, it is critical that the Exchangor has little or no personal use of the property for a considerable period of time.
How long until the Exchangor can convert the investment to personal use?There is no bright line test to determine how little personal use is safe for the exchange and how much personal use is dangerous for the exchange.
The safest approach is to rent the property to third parties at fair market rent with no personal use of the property by the Exchangor.
How Long before Conversion to Personal Use by the Exchangor?
There is no bright line test for the length of time the Replacement Property must be held as an investment by the Exchangor. The General Rule: the Longer the Better. Many tax advisors would suggest that a period exceeding 12 months and spanning two tax years is a minimum safe period.
Example: Replacement property is acquired in November 2003. The property is rented, at a fair market rent, to third parties for the two months remaining of tax year 2003 and all of tax year 2004. In early tax year 2005, the property is converted by the Exchangor to personal use.
Because this area is murky at best, the facilitator should always refer the Exchangor to his or her accountant to determine the rules for the Exchangor's use of the Replacement Property.
In the final analysis, it is the accountant who will be working with the Exchangor to determine tax filing positions on the replacement property.
Copyright 2002, Exchange Facilitator Corporation, all rights reserved
Hope this info helps. There is a lot of good information on the internet regarding 1031 Exchanges and what qualifies and what does not.
SandyComment
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Sad but true
Sad but true. Since the replacement property was not rented, there is no question of 1031 treatment, and it's too late to fix. Don't blame 1st American. It's not their job to determine how the property is used. Any advice like that would make them the taxpayer's agent, not a qualified intermediary.Comment
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Agree with Jainen
I think your taxpayer might not have given all the right info to the Facilitator, the facilitator also had the taxpayer probably sign some type of disclaimer, that they were not responsible, if the 1031 exchange failed for reasons outside of their particular duties (like not meeting deadlines, disbursing funds, etc)
It would seem, altho I think "iffy" the property might have been qualified for a 1031 exchange based on investment (appreciation) even though it had not been rented, but the fact that the taxpayer tried to complete the 1031 and then occupy as a personal residence, I think negates the whole transaction.
If you want more info, let me know and I will give you links to some very good 1031 exchange sites.
SandyComment
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Sandy, would
appreciate some web sites with good 1031 info. I have looked at 1031cpas.com.
Thanks!
PeggypeggysiouxComment
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1031 Websites
Peggy, Here's some links.
Most everyone of these people will talk to you if you have a question.
Good Luck
SandyComment
Comment