So you exchanged into that bright, shiny new rental property and now things have changed. For some reason, perhaps many reasons, you want to move into the new property instead of renting it. What effect, if any, will that have on your exchange?

Recently the U.S. Tax Court ruled in favor of a couple who moved into a property they acquired in an exchange eight months earlier. The couple overcame an IRS challenge to their exchange, and the facts and circumstances of their story can be helpful to us all. The case summary below was provided by the Federation of Exchange Accommodators, our national association, with minor editing and modifications. Please see our comments about this case below the italicized text.

In Reesink vs. C.I.R., T.C. Memo 2012-118, No. 2475-10 (April 23, 2012), the U.S. Tax Court considered whether a single-family house was acquired by the taxpayers as a personal residence or as an investment.  
The facts of the case: In 2005, the taxpayers sold a San Francisco apartment building, entered into an exchange, and acquired a single-family house and a vacant lot in Guerneville, CA.  The taxpayers' mortgage loan application indicated that the property was purchased as an investment.  "For Rent" signs were posted on the property.  Flyers were distributed throughout Guerneville advertising the property for rent.  Two prospective tenants examined the property to consider leasing it, but each decided that they could not afford the asking price of $3,000 per month.  The taxpayers never lowered their asking price.  The property was never advertised for rent in any local newspaper.  The court did not say if the property was ever listed for rent with a real estate broker, although the taxpayers consulted with one.  

After failing to rent the Guerneville property for some time, Mr. Reesink wanted sell their San Francisco home because they could not afford the carrying costs of all the real estate that they owned.  Mrs. Reesink resisted this idea because she liked living in San Francisco and because she did not want to take their son out of his current high school.  Nevertheless, the parties listed their home in San Francisco in April, 2006, about six months after they acquired the Guerneville property.  At that time, the Reesinks considered either moving to Guerneville or moving in with Mr. Reesink's sister.  Two months later, when their San Francisco home was sold, they elected to move to Guerneville.  That was almost eight months after they acquired the Guerneville property.  Until they moved in, they had never stayed in the Guerneville property or used it for any personal purpose.  

Based on this information, the IRS threw out their exchange based on the concept that the Reesinks had not acquired the Guerneville property for investment purposes. However, the Tax Court ruled in favor of the Reesinks, finding that the principal intention of the taxpayers in acquiring the Guerneville property was for investment, not personal use.  The court stated that perhaps the strongest evidence of the Reesinks' investment intent came from Mr. Reesink's estranged brother, who was actually a witness for the IRS, testifying that Mr. Reesink told him on several occasions that they planned to move to the Guerneville property after their son graduated from high school.  That would have been significantly more than two years after they acquired the Guerneville property.  This testimony gave weight to the position of the taxpayers that they had changed their minds because of financial difficulties when they decided to move to Guerneville in 2006.
In concluding that the taxpayers had satisfied their burden of proving that they held the Guerneville property principally for investment, the court distinguished this case from an earlier one, Goolsby v. Commissioner, T.C. Memo. 2010-64. In Goolsby, the Tax Court found that the taxpayers did not have a bona fide investment intention when they acquired replacement property.  The court in Reesink pointed out that in Goolsby, the taxpayers: 

  • made the purchase of the replacement property contingent on the sale of their home
  • sought advice concerning when they could move into the replacement property
  • placed only one advertisement in a local newspaper
  • began refinishing the basement of the replacement property within two weeks of acquiring it, and
  • moved into the replacement property within two months of acquiring it.

The distinctions between Goolsby and Reesink begin to mark a line describing the burden of proof that taxpayers will be expected to meet if they move into residential replacement property before the end of the two-year safe harbor holding period provided by Rev. Proc. 2008-16.

Comments: The “Bottom Line”  

We are often asked how long a property must be held before it can be sold and used in an exchange. We respond by citing the fact that there is no specified time period in the code and it depends upon the intention for the acquisition. As an exchange intermediary, we cannot interpret the regulations for an individual taxpayer, but we can tell the taxpayer what the regulations say. We have always stressed that intent is more critical than length of ownership. The case above points out how important documentation of intent can be. The Reesinks might well have lost their appeal had they not been able to establish and document the actions they took prior to moving into the property. Here are some things to consider in regards to documenting the facts:

  • If there is a loan on the new property, is it a “second home loan” or an investment property loan?
  • What type of insurance policy is on the property? Is it “Residence” or “Rental” coverage?
  • Has the property been offered for rent at a fair market rate? 
  • How and where has the property been marketed?
  • Have you or a family member used the property for personal use? (Don’t forget, the IRS can subpoena utility records, credit card records, etc.)
  • What circumstances that led to the decision to move into the property? Be sure to document them, perhaps in a contemporaneous memo to the house file or in a letter to your tax preparer.
  • How much time has passed between the acquisition of the replacement property and the conversion to a residence?  While not the determining factor, it is clear that the more time has passed, the better.

In my speaking engagements, a theoretical example I often use is the landlord who buys a house with the intention of renting it. He advertises it and signs a one-year lease with a couple. Three months later, the couple wins the lottery. They’ve lived there long enough to know it will be a fine home for them and they make the landlord an offer to buy the house for $25,000 more than he paid four months earlier. Based on intent, I would argue that the property could be exchanged. (I would also strongly advise the landlord to discuss the matter with his tax advisor before moving ahead!) If the landlord does enter into an exchange, will it survive IRS scrutiny? Of course, no one can answer that today. Clearly, though, the more the facts can be documented, the stronger the case would be for the landlord. 

We always recommend that you discuss your transaction with your tax and/or legal advisor to determine the best way to proceed in your particular situation.

If you are selling your property and would like to discuss the pros and cons of a Section 1031 tax-deferred exchange, please contact Iowa Equity Exchange.