Recent Tax Court Case Affirms 1031 Exchange Intent

A recent 2012 Tax Court case, which allowed a coupleto move into their 1031 replacement property eight months after the purchase, will once again excite those investors who focus on intent, rather than a minimum holding period to qualify for a 1031 exchange.

Section 1031 says that to be eligible to do an exchange, you have to have intent to hold the property as an investment, and if your intent is to hold the property for resale, you're not eligible to do an exchange. The problem with all this is that Section 1031 does not define the terms intent, investment or resale.

A large body of investors and investment advisors hold that if your intent is to hold the property for a profit, then you qualify for a 1031 exchange regardless of the holding period. Over the years we've dealt with attorneys and CPAs who insist that if you have a profit intent, you should be able to exchange a property that you've owned for as little as a day or two.

Not surprisingly, since the code section does not define these important terms, there is a fairly large number of court cases with taxpayers and the IRS fighting over this issue, and taxpayers win just enough of them to keep the hope alive.

In this most recent court case, the taxpayers sold an apartment house and exchanged into single-family rental. For eight months they tried unsuccessfully to rent the house and then were forced by financial problems to sell their primary home and move into the rental house. The IRS subsequently disallowed the exchange, and the couple took it to tax court where they were able to convince the judge that their efforts to rent the property were substantial and their financial problems legitimate.

I'm sure that the intent pundits will applaud this outcome as further proof that intent arguments can win the day for them. I think this view is short-sighted because they overlook the tremendous cost of going to tax court, and the fact that the odds that are stacked against them once they get there. By my unofficial count, taxpayers have only won maybe 10% of these cases.

The court typically rules that you have to hold the property for two tax years in order to qualify for an exchange. Since January 1st to January 1st is two tax years (as is December 1st to January 1st) the IRS informally considers 366 days as the minimum holding period to meet the investment definition. 366 days, or "a-year-and-a-day," meets the two-tax year court definition, but it also meets the minimum holding period requirement to qualify for the more preferential tax definition of a long-term capital gain.

What I tell my clients is that while there are taxpayers who've won the battle with the IRS over a short holding period based upon intent, if you're adamant about doing an exchange on property that you've owned for less than a year-and-a-day, you better be prepared to go to war with the IRS because they will challenge short holding periods. Is it really worth spending the next 3 years looking over your shoulder?