Question

Linda Robinson purchased an apartment building in 2010 and decided in 2018 to sell the apartment building. She realized a gain of $400,000. Linda wanted to defer any recognized gain, so she worked with a realtor to identify property that would be eligible for § 1031 like-kind exchange treatment. She found a single-family home in Dallas, TX that was currently being rented by the owner. Linda purchased the single-family house using the proceeds from the apartment building. Because the single-family house qualified as like-kind property, Linda deferred all of her realized gains.

After evicting the occupant and trying to rent the property again for ten months, Linda decided that she could not continue to make the mortgage payments on her primary residence and the rental property. To ease her financial problem, Linda sold her primary residence for a realized gain of $190,000 and moved into the Dallas house. She reported no recognized gain on the sale of her principal residence as the sale qualified for § 121 exclusion treatment. The IRS issued a deficiency notice to Mary associated with the sale of the apartment building. The position of the IRS was that Linda did not hold the single-family residence for investment purposes as required by § 1031. Instead, her intention was personal—to use it as a replacement for her current residence that she planned on selling.

Advise her on who should prevail in the circumstances via a Client Letter after preparing sufficient information in a tax File Memorandum to support your recommendation.

Answer 1

The main contention of IRS is that Linda did not hold the single family residence for investment purposes as required by section 1031 but rather she purchased it with the intention of using it as her personal residence.IRS is of the view that Linda had planned this in advance.

Under section 121, any gain arising on sale of a primary residence or principal residence is excluded from capital gains tax up to an amount of $ 250,000. To qualify as a primary residence, must have owned and resided in the property for atleast 2 years of the most recent 5 year period. The 2 years need not be consecutive. As far as the realized gain of $ 190,000 on sale of Linda's primary residence , she is correct in excluding the same from capital gains tax as she is eligible for an exclusion of up to 250,000 as an individual.

However in the case of the single family residence in Dallas which was purchased as the exchange property under section 1031, the circumstances puts the investment under a cloud from a tax perspective. The IRS's argument that Linda had purchased the Dallas property with the intention of converting into her primary residence may hold ground because the property had not been rented out though she had put in her best efforts and the sale of her primary residence and moving into the single family residence was more to do with her financial condition. But the IRS may ignore that side of the story.Hence it had not been used for any productive purpose for nearly 10 months.Also the fact that Linda had evicted the previous tenant may also work against her.If she had continued with the existing tenant she would have received rental income in which case it can be argued that it was an investment property.

Under the given circumstances, the only way to convince IRS is for LInda to commit that she would be holding the replacement property for atleast a 5 year period post the exchange eventhough the requirement for fulfilling the condition of a primary residence is only for 2 years After owning the property for 5 years and using it as a primary residence for a minimum of 2 years during the 5 year period, Linda can decide to sell the property and avail benefits under section 21.