SECTION 1031 EXCHANGES OF VACATION HOMES
AND MIXED USE PROPERTIES
© 2005, Charles H. Egerton, Esq.
Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A.
Orlando, Florida
I.
OVERVIEW.
A.
Section 1031(a)(1) Requirements. Section 1031(a)(1) provides as follows:
No gain or loss shall be recognized on the exchange of
property held for productive use in a trade or business or
for investment if such property is exchanged solely for
property of like-kind which is to be held either for
productive use in a trade or business or for investment.
[Emphasis added]
B.
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Holding Purpose Tests. As noted in the italized portions of the quote from
§1031(a)(1) in I.A.1 above, both the relinquished property and the replacement
property must be held by the taxpayer either for productive use in a trade or
business or for investment.
1.
Property held for productive use in a trade or business may be exchanged
for property held for investment or vice versa. Reg. §1.1031(a)-1(a)(1).
2.
Neither the Code nor the applicable regulations provide much guidance
with regard to the determination of when properties will be deemed to be
held “for productive use in a trade or business” or “for investment.”
(a)
Presumably, use in a “trade or business” would have the same
meaning under §1031 as in §§167, 1221(2) and 1231. However,
§§167, 1221(2) and 1231 refer to property “used in the trade or
business,” while §1031(a)(1) refers to property “held for
productive use in a trade or business.” The “held for” language
suggests that property acquired for, but not yet committed to, use
in a trade or business may still meet the trade or business test for
purposes of §1031. See Levine, Taxfree Exchanges under Section
1031, 567-2nd BNA Tax Mgt Portfolio A-3; Sen. Finance
Committee Report, S. Rep. No. 398, 68th Cong., 1st Sess. 14 (1923).
(b)
Likewise, very little guidance is available to identify “investment
property,” but Reg. §1.1031(a)-1(b) includes the following helpful
example:
Unproductive real estate held by one other than a
dealer for future use or future realization of the
increment in value is held for investment . . .”
3.
II.
Property held for personal use, such as a principal residence or a “second
home” used solely for personal enjoyment is not eligible for §1031
nonrecognition treatment because it is neither held for productive use in a
trade or business nor for investment. See, e.g., FSA 1918258(7/14/95);
PLR 8508095(11/29/84).
VACATION HOMES.
A.
Vacation Homes. A “vacation home” owned by a taxpayer can be used in a
variety of ways. Such properties, which range from mountain or lakefront houses
to beachfront condominiums, can be used (i) exclusively for personal purposes;
(ii) primarily for personal purposes but with occasional rentals; (iii) primarily for
rental purposes but with occasional personal use; and (iv) exclusively for rental
purposes.
1.
The primary issue that must be addressed in attempting to structure a
disposition of a vacation home as a qualified §1031 exchange is whether
both the relinquished property and the replacement property will be
deemed to be held by the taxpayer either for productive use in a trade or
business or for investment.
2.
A vacation home which is used exclusively for personal purposes will
clearly be ineligible for §1031 nonrecognition treatment. I.B.3, supra. If
the vacation home is not the taxpayer’s principal residence (which is
usually the case with a vacation home), §121 will also not be available to
shelter gains on disposition from taxation.
3.
A vacation home that is held solely for bona fide rental purposes (i.e., no
personal use by the taxpayer) will constitute property held for productive
use in a trade or business (if the business activities associated with the
rental of the home rise to the level of an active trade or business) or for
investment purposes.
(a)
Query: whether property listed with a rental agent but which is
never actually rented will qualify? The use of the words “held for”
in §1031(a)(1) may help, but the taxpayer will presumably have
the burden of proof that he had a bona fide intent to rent and made
reasonable efforts to secure the rental of the vacation home.
(b)
If the taxpayer rents the home on a regular basis but the rentals are
solely to family members and at less than arms’ length rates, this
may not be deemed to be a bona fide rental use of the property.
Cf. §§280A(d)(2) and (3), which may or may not be analogous, but
which require the property to be rented at a fair rental value in
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order to be regarded as “rental use.”
4.
The more difficult questions arise when the taxpayer both rents and
personally uses the vacation home. Neither the IRS nor the courts have
directly addressed this issue in the context of a §1031 exchange as of the
date of this outline.
(a)
Is there any merit in utilizing the criteria applied in §280A, which
limits the deductions a taxpayer may claim on a vacation home
under several different tests which are tied to the number of days
or percentage of use for personal purposes vis-à-vis the number of
days or percentage of use for bona fide rental purposes, in
determining whether or to what extent a vacation home will be
deemed to be held for productive use in a trade or business or for
investment purposes? Since the scope of §280(A) is very narrow
and its purposes are entirely different than §1031, it is submitted
that the §280(A) tests are not appropriate for application under
§1031.
(b)
The more appropriate test would be to focus on the principal
purpose of the taxpayer with respect to his ownership and use of
the vacation home as determined at the time of the exchange. This
would entail a facts and circumstances analysis which examines
the degree of personal use versus actual rental and/or bona fide
holding of property for rental over a period of time. This approach
finds at least implied support in Margolis v. Commissioner, 337
F.2d 1001 (9th Cir. 1964) in which the court explored the true
intent of the taxpayer with respect to properties disposed of by him
in purported §1031 exchanges. The taxpayer was an admitted
“dealer” in real estate who nevertheless claimed that the properties
exchanged, consisting in part of residential lots and the balance in
commercial parcels, were held by him for investment purposes.
The court applied a facts and circumstances analysis and held that
the residential lots were dealer properties, thereby rendering them
ineligible for nonrecognition of gain under §1031(a)(2)(A), but
also held that the taxpayer had a true investment intent with respect
to the commercial lots based upon his track record of not disposing
of these commercial parcels but rather developing them for rental
purposes.
(i)
Prior extensive personal use of a vacation home by a
taxpayer can be overcome if the taxpayer demonstrates that
her purposes for holding the vacation home have changed,
as evidenced by predominant rental use of the property in
recent years coupled with little or no personal use. See,
Rev. Rul. 57-244, 1957-1 C.B. 247; PLR 8103117
(10/27/80).
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(c)
5.
(ii)
Should the line be drawn at only incidental personal use or
would it be sufficient for the taxpayer to merely
demonstrate, for example, that she rented a vacation home
for a fair rental value for 51% of the actual days the home
was used and then used the property for personal purposes
for 49% of the days of actual usage?
(iii)
Should the total number of days of actual use matter? For
example, should a distinction be drawn between a vacation
home that was used only 15 days during the course of a
year, 8 of which were for rental purposes and the remaining
7 for personal purposes, as opposed to a property that was
rented for 120 days during the year versus 60 days of
personal use? Cf. §280A(g) which disallows any
deductions for depreciation, etc. if a dwelling unit is
actually rented for less than 15 days during a taxable year.
If the appropriate test is a predominant or principal purpose test, or
even if the test ultimately turns out to be a bifurcated approach
using a §280A model, can a taxpayer plan ahead and cut back or
eliminate his personal use of a vacation home, rent the property for
a substantial number of days, and thereby convert the property
from personal use to investment or business use? The answer
should clearly be yes. See, Rev. Rul. 57-244, supra; and PLR
8103117, supra. However, what period of time will be sufficient
to demonstrate this change of purpose? Although there are no
bright line standards that can be applied for this purpose, it is
suggested that a sliding scale might be a practical approach. Thus,
if the taxpayer clearly used the vacation home predominantly for
personal purposes in the past, a longer period of clear rental use,
such as 2 to 5 years, would be appropriate, but a lesser period
might be required for a home that was rented a significant amount
of time in the past coupled with a more limited use for personal
purposes.
Vacation homes which are disposed of in the resale market are frequently
sold on a fully furnished basis. In such a case, any furniture, equipment
and supplies which are included with the vacation home will not constitute
real property. Consequently, the taxpayer should incorporate a reasonable
allocation of the sales price of the relinquished property between the real
estate component and the tangible personal property, and should further
suballocate the sales price among items of tangible personal properties
which may fall within different General Asset Classes or Product Classes.
The same allocation and suballocation approach should also be employed
in the acquisition of a furnished replacement vacation home.
(a)
These detailed allocations are necessary because the IRS and
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Treasury have applied §1031 on a much narrower basis with
respect to tangible personal properties than in the case of real
estate. Compare Regs. §1.1031(a)-1(b), which, for example,
permits an exchange of unimproved real property for improved
real property and even treats a 30 plus year lease as real property
eligible for nonrecognition under §1031, with Regs. §1.1031(a)-2
which treats tangible personal properties as “like-kind” only if they
are literally like-kind or if they are of “like-class.” Such properties
are deemed to be of “like-class” only if they are included even
within the same General Asset Class, as defined in Regs.
§1.1031(a)-2(b)(2), or the same Product Class, as defined in Regs.
§1-1031(a)-2(b)(3).
III.
(b)
In addition to the necessity of determining that the tangible
personal properties disposed of, and received, in an exchange are
of like-kind or like-class, it is also necessary to demonstrate that
the fair market value of any §1245 properties received by the
taxpayer in the exchange is at least equal to the fair market value
of the §1245 properties that were disposed of by him in the
exchange in order to avoid depreciation recapture under
§1245(b)(4).
(c)
The allocation provisions should also require the parties to report
the transaction in accordance with these allocation provisions for
both federal and state income tax reporting purposes.
MIXED USE PROPERTIES.
A.
Background. Taxpayers sometimes own real properties which are used both for
trade or business purposes and for personal purposes.
1.
For example, a physician may use a portion of his house as an office to
conduct his business of examining and treating patients while using the
balance of the house as a principal residence.
2.
A more common example is a personal residence in which a business
person maintains an office that is used by him exclusively for business
purposes and which otherwise meets the requirements of §280A(c)(1).
3.
A taxpayer may also have a detached structure that is used exclusively for
business purposes but which is located on the same parcel of real property
on which the taxpayer’s principal residence is also situated.
4.
Husband and wife may acquire a house which is used by them for seven
years as their principal residence. At the end of the seventh year, they
move out of the house and convert it to rental property. Sometime prior to
the tenth year of ownership, the property is disposed of in a §1031
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exchange.
B.
Is it Possible to Apply both Section 121 and Section 1031 to the Disposition of
Mixed Use Properties?
1.
Section 121 permits a taxpayer to exclude up to $250,000 ($500,000 in the
case of married taxpayers filing a joint return) of gains from the sale of a
principal residence under certain circumstances. Taxpayers and their
advisors have speculated for some time as to whether it is possible to
structure a disposition of mixed use property (or property converted from
one use to the other) in such a manner as to take advantage of the
exclusion of gains under §121 and the deferral of remaining gains under
§1031. Until recently, no significant guidance was available either from
the IRS or the courts on this issue.
2.
Rev. Proc. 2005-14, 2005-7 IRB 1 was recently issued by the IRS. This
revenue procedure provides helpful guidance which not only permits the
dual use of §§121 and 1031 to the disposition of mixed use (or converted
use) properties, but also explains how the exclusion rules of §121 interact
with the deferral rules of §1031. Although acknowledging that neither
§121 nor §1031 addresses the application of these provisions to a single
exchange of property, they nevertheless analogize the application of these
two provisions to the methods employed under §121(d)(5)(D) in applying
both §121 and §1033 to a principal residence that is destroyed or
involuntarily converted. See, Rev. Proc. 2005-14, Section 2.09.
3.
Section 3 of Rev. Proc. 2005-14 specifically notes that the application of
both §121 and §1031 to exchange of property will only be available if the
property meets all of the requirements of §121 and, in addition, the portion
of the property to which §1031 is to be applied must also be held by the
taxpayer for productive use of a trade or business or for investment.
Likewise, the replacement property received in the §1031 exchange must
be like kind to the relinquished property and must also be held by the
taxpayer for productive use in a trade or business or for investment.
4.
The operating rules for the dual application of §§121 and 1031 to an
exchange of property are primarily set forth in section 4 of Rev. Proc.
2005-14.
(a)
Section 4.01 of Rev. Proc. 2005-14 begins with an affirmation that
taxpayers may apply both the exclusion of gain from the exchange
of a principal residence under §121 and the nonrecognition (i.e.,
deferral) of gain from the exchange of like kind properties under
§1031 in accordance with the procedures set forth therein.
(b)
The general rules governing the computation of the amount of gain
to be recognized for tax purposes are contained in section 4.02 of
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Rev. Proc. 2005-14, which are as follows:
(c)
5.
(i)
Section 121 must be applied to gain realized before
applying §1031.
(ii)
Under §121(d)(6), the §121 exclusion does not apply to
gain attributable to depreciation deductions for periods
after May 6, 1997 claimed with respect to the business or
investment portion of the residence; however, §1031 may
apply to such gain.
(iii)
In applying §1031, cash or other non-like kind property
(i.e., boot) received in exchange for property used in the
taxpayer’s trade or business or held for investment (i.e., the
relinquished business property), is taken into account only
to the extent that the boot exceeds the gain excluded under
§121 with respect to the relinquished property.
(iv)
Section 2.04 of Rev. Proc. 2005-14 also notes that, for
purposes of determining the amount of gain allocable to the
residential and business portions of the property, the
taxpayer must allocate basis and the amount realized using
the same method of allocation the taxpayer used to
determine depreciation adjustments (as defined in
§1250(b)(3)). The subsection goes on to note that an
allocation based on the square footage of the residential and
business portions of the property is an appropriate method
of allocating the basis and the amount realized.
In determining the tax basis of the qualifying replacement property
received in the exchange, any gain excluded under §121 is treated
as gain recognized by the taxpayer. Thus, under §1031(d) the
basis of the replacement business property is increased by any gain
attributable to the relinquished business property that is excluded
under §121.
The examples set forth in section 5 of Rev. Proc. 2005-14 provide helpful
guidance for applying these rules to several fairly common situations.
These will be set forth below in their entirety. In each example, the
taxpayer is an unmarried individual and the property or a portion of the
property has been used in the taxpayer’s trade or business or held for
investment within the meaning of §1031(a) as well as used as a principal
residence as required under §121.
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Example 1. Exchange of former principal residence converted to rental
use.
(i)
Taxpayer A buys a house for $210,000 that A uses as A’s
principal residence from 2000 to 2004. From 2004 until
2006, A rents the house to tenants and claims depreciation
deductions of $20,000. In 2006, A exchanges the house for
$10,000 of cash and a townhouse with a fair market value
of $460,000 that A intends to rent to tenants. A realizes
gain of $280,000 on the exchange.
(ii)
A’s exchange of a principal residence that A rents for less
than three years for a townhouse intended for rental and
cash satisfies the requirements of both §§121 and 1031.
Section 121 does not require the property to be the
taxpayer’s principal residence on the sale or exchange date.
Because A owns and uses the house as A’s principal
residence for at least two years during the five-year period
prior to the exchange, A may exclude gain under §121.
Because the house is investment property at the time of the
exchange, A may defer gain under §1031.
(iii)
Under section 4.02(1) of [Rev. Proc. 2005-14], A applies
§121 to exclude $250,000 of the $280,000 gain before
applying the nonrecognition rules of §1031. A may defer
the remaining gain of $30,000, including the $20,000 gain
attributable to depreciation, under §1031. See section
4.02(2) of this revenue procedure. Although A receives
$10,000 of cash (boot) in the exchange, A is not required to
recognize gain because the boot is taken into account for
purposes of §1031(b) only to the extent the boot exceeds
the amount of excluded gain. See section 4.02(3) of [Rev.
Proc. 2005-14].
These results are illustrated as follows:
Amount Realized
Less: Adjusted Basis
Realized Gain
Less: Gain Excluded under §121
Gain to be Deferred
(iv)
A’s basis in the replacement property is $430,000, which is
equal to the basis of the relinquished property at the time of
the exchange ($190,000) increased by the gain excluded
under §121 ($250,000), and reduced by the cash A receives
($10,000). See section 4.03 of [Rev. Proc. 2005-14].
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$470,000
$190,000
$280,000
$250,000
$ 30,000
Example 2. Separate principal residence and guest house used as office.
(i)
Taxpayer B buys a property for $210,000. The property
consists of two separate dwelling units (within the meaning
of §1.121-1(e)(2)), a house and a guesthouse. From 2001
until 2006, B uses the house as B’s principal residence and
uses the guesthouse as an office in B’s trade or business.
Based on the square footage of the respective parts of the
property, B allocates 2/3 of the basis of the property to the
house and 1/3 to the guesthouse. In 2006, B exchanges the
entire property for a residence and a separate property that
B intends to use as an office. The total fair market value of
B’s replacement properties is $360,000. The fair market
value of the replace residence is $240,000 and the fair
market value of the replacement business property is
$120,000, which is equal to the fair market value of the
relinquished business property. From 2001 to 2006, B
claims depreciation deductions of $30,000 for the business
use. B realizes gain of $180,000 on the exchange.
(ii)
Under §121, B may exclude gain of $100,000 allocable to
the residential portion of the house (2/3 of $360,000
amount realized, or $240,000, minus 2/3 of $210,000 basis,
or $140,000) because B meets the ownership and use
requirements for that portion of the property. Because the
guesthouse is business property separate from the dwelling
unit and B has not met the use requirements for the
guesthouse, B may not exclude the gain allocable to the
guesthouse under §1.121-1(e). However, because the fair
market value of the replacement business property is equal
to the fair market value of the relinquished business
property and B receives no boot, B may defer the
remaining gain of $80,000 (1/3 of $360,000 amount
realized, or $120,000, minus $40,000 adjusted basis, which
is 1/3 of $210,000 basis, or $70,000, adjusted by $30,000
depreciation) under §1031.
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These results are illustrated as follows:
Total
Property
Amount Realized
Basis
Depreciation Adjustment
Adjusted Basis
Realized Gain
Gain Excluded
under §121
Gain Deferred
under §1031
(iii)
2/3 Residential 1/3 Business
Property
Property
$360,000
$210,000
$ 30,000
$180,000
$180,000
$240,000
$140,000
$100,000
$100,000
$ 80,000
$140,000
$100,000
$120,000
$ 70,000
$ 30,000
$ 40,000
$ 80,000
$ 80,000
Because no portion of the gain attributable to the
relinquished business property is excluded under §121 and
B receives no boot and recognizes no gain or loss in the
exchange, B’s basis in the replacement business property is
equal to B’s basis in the relinquished business property at
the time of the exchange ($40,000). B’s basis in the
replacement residential property is the fair market value of
the replacement residential property at the time of the
exchange ($240,000).
Example 3. House used 2/3 for principal residence and 1/3 as office.
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(i)
Taxpayer C buys a property for $210,000. The property
consists of a house that constitutes a single dwelling unit
under §1.121-1(e)(2). From 2001 until 2006, C uses 2/3 of
the house (by square footage) as C’s principal residence
and uses 1/3 of the house as an office in C’s trade or
business. In 2006, C exchanges the entire property for a
residence and a separate property that C intends to use as
an office in C’s trade of business. The total fair market
value of C’s replacement properties is $360,000. The fair
market value of the replacement residence is $240,000 and
the fair market value of the replacement business property
is $120,000, which is equal to the fair market value of the
business portion of the relinquished property. From 2001
to 2006, C claims depreciation deductions of $30,000 for
the business use. C realizes gain of $180,000 on the
exchange.
(ii)
Under §121, C may exclude the gain of $100,000 allocable
to the residential portion of the house (2/3 of $360,000
amount realized, or $240,000, minus 2/3 of $210,000 basis,
or $140,000) because C meets the ownership and use
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requirements for that portion of the property.
(iii)
The remaining gain of $80,000 (1/3 of $360,000 amount
realized, or $120,000, minus $40,000 adjusted basis, which
is 1/3 of $210,000 basis, or $70,000, adjusted by $30,000
depreciation) is allocable to the business portion of the
house (the office). Under section 4.02(1) of [Rev. Proc.
2005-14], C applies §121 before applying the
nonrecognition rules of §1031. Under §1.121-1(e), C may
exclude $50,000 of the gain allocable to the office because
the office and residence are part of a single dwelling unit.
C may not exclude that portion of the gain ($30,000)
attributable to depreciation deductions, but may defer the
remaining gain of $30,000 under §1031.
These results are illustrated as follows:
Amount Realized
Basis
Depreciation Adjustment
Adjusted Basis
Realized Gain
Gain Excluded
under §121
Gain Deferred
under §1031
(iv)
Total
Property
2/3 Residential 1/3 Business
Property
Property
$360,000
$210,000
$ 30,000
$180,000
$180,000
$240,000
$140,000
$140,000
$100,000
$120,000
$ 70,000
$ 30,000
$ 40,000
$ 80,000
$150,000
$100,000
$ 50,000
$ 30,000
$ 30,000
C’s basis in the replacement residential property is the fair
market value of the replacement residential property at the
time of the exchange ($240,000). C’s basis in the
replacement business property is $90,000, which is equal to
C’s basis in the relinquished business property at the time
of the exchange ($40,000), increased by the gain excluded
under §121 attributable to the relinquished business
property ($50,000). See section 4.03 of [Rev. Proc. 200514].
Example 4. Same as Example 3 except that $10,000 of cash boot received.
(i)
The facts are the same as in Example 3 except that C also
receives $10,000 of cash in the exchange and the fair
market value of the replacement business property is
$110,000, which is $10,000 less than the fair market value
of the business portion of the relinquished property
($120,000).
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(ii)
Under §121, C may exclude the gain of $100,000 allocable
to the residential portion of the house (2/3 of $360,000
amount realized, or $240,000, minus 2/3 of $210,000 basis,
or $140,000).
(iii)
The remaining gain of $80,000 (1/3 of $360,000 amount
realized, or $120,000, minus $40,000 adjusted basis) is
allocable to the business portion of the house. Under
section 4.02(1) of [Rev. Proc. 2005-14], C applies §121 to
exclude gain before applying the nonrecognition rules of
§1031. Under §1.121-1(e), C may exclude $50,000 of the
gain allocable to the business portion of the house but may
not exclude the $30,000 of gain attributable to depreciation
deductions. Under section 4.02(2) of [Rev. Proc. 2005-14],
C may defer the $30,000 of gain under §1031. Although C
receives $10,000 of cash (boot) in the exchange, C is not
required to recognize gain because the boot is taken into
account for purposes of §1031(b) only to the extent the
boot exceeds the amount of excluded gain attributable to
the relinquished business property. See 4.02(3) of [Rev.
Proc. 2005-14].
These results are illustrated as follows:
Amount Realized
Basis
Depreciation Adjustment
Adjusted Basis
Realized Gain
Gain Excluded
under §121
Gain Deferred
under §1031
Total
Property
2/3 Residential 1/3 Business
Property
Property
$360,000
$210,000
$ 30,000
$180,000
$180,000
$240,000
$140,000
$140,000
$100,000
$110,000 + $10,000
$ 70,000
$ 30,000
$ 40,000
$ 80,000
$150,000
$100,000
$ 50,000
$ 30,000
$ 30,000
Example 5. Same as Example 3 except that fair market value of
replacement properties is $540,000.
(i)
The facts are the same as in Example 3 except that the total
fair market value of the replacement properties is $540,000.
The fair market value of the replacement residence is
$360,000, the fair market value of the replacement business
property is $180,000, and C realizes gain of $360,000 on
the exchange.
(ii)
Under §121, C may exclude the gain of $220,000 allocable
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to the residential portion of the house (2/3 of $540,000
amount realized, or $360,000, minus 2/3 of $210,000 basis,
or $140,000).
(iii)
The remaining gain of $140,000 (1/3 of $540,000 amount
realized, or $180,000, minus $40,000 adjusted basis) is
allocable to the business portion of the house. Under
section 4.02(1) of [Rev. Proc. 2005-14], C excludes the
gain before applying the nonrecognition rules of §1031.
Under §1.121-1(e), C may exclude $30,000 of the gain
allocable to the business portion, at which point C will have
excluded the maximum limitation amount of $250,000. C
may defer the remaining gain of $110,000 ($140,000
realized gain minus the $30,000 gain excluded under §121),
including the $30,000 gain attributable to depreciation,
under §1031.
These results are illustrated as follows:
Amount Realized
Basis
Depreciation Adjustment
Adjusted Basis
Realized Gain
Gain Excluded
under §121
Gain Deferred
under §1031
(iv)
Total
Property
2/3 Residential 1/3 Business
Property
Property
$540,000
$210,000
$ 30,000
$180,000
$360,000
$360,000
$140,000
$140,000
$220,000
$180,000
$ 70,000
$ 30,000
$ 40,000
$140,000
$250,000
$220,000
$ 30,000
$110,000
$110,000
C’s basis in the replacement residential property is the fair
market value of the replacement residential property at the
time of the exchange ($360,000). C’s basis in the
replacement business property is $70,000, which is equal to
C’s basis in the relinquished business property ($40,000),
increased by the amount of the gain excluded under §121
($30,000). See section 4.03 of [Rev. Proc. 2005-14].
Example 6. Same as Example 3 except that fair market value of
replacement properties is $750,000.
(i)
The facts are the same as in Example 3 except that the total
fair market value of the replacement properties is $750,000.
The fair market value of the replacement residence is
$500,000, the fair market value of the replacement business
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property is $250,000, and C realizes gain of $570,000 on
the exchange.
(ii)
The gain allocable to the residential portion is $360,000
(2/3 of $750,000 amount realized, or $500,000, minus 2/3
of $210,000 basis, or $140,000). C may exclude gain of
$250,000 from gross income under §121. C must include
in income the gain of $110,000 allocable to the residential
portion that exceeds the §121(b) exclusion limitation
amount.
(iii)
The remaining gain of $210,000 (1/3 of $750,000 amount
realized, or $250,000, minus $40,000 adjusted basis) is
allocable to the business portion of the house. C may defer
the $210,000 of gain, including the $30,000 gain
attributable to depreciation, under §1031.
These results are illustrated as follows:
Amount Realized
Basis
Depreciation Adjustment
Adjusted Basis
Realized Gain
Gain Excluded
under §121
Gain Deferred
under §1031
Gain Recognized
(iv)
C.
2/3 Residential 1/3 Business
Property
Property
$750,000
$210,000
$ 30,000
$180,000
$570,000
$500,000
$140,000
$250,000
$250,000
$210,000
$110,000
$110,000
$140,000
$360,000
$250,000
$ 70,000
$ 30,000
$ 40,000
$210,000
$210,000
C’s basis in the replacement residential property is the fair
market value of the replacement residential property at the
time of the exchange ($500,000). C’s basis in the
replacement business property is $40,000, which is equal to
C’s basis in the relinquished business property at the time
of the exchange.
Dual Use of Sections 121 and 1031 Partially Restricted under JOBS Act. Section
121(d), as amended by the American Jobs Creation Act of 2004, Pub. L. 108-357,
provides that if a taxpayer acquired property in an exchange to which §1031
applied, the §121 exclusion will not apply if the sale or exchange of such property
occurs within the five-year period beginning with the date of acquisition of such
property. This provision is effective for sales or exchanges after October 22,
2004.
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Total
Property
D.
Loss Disallowed; Duration of Conversion. In J. Clark Bundren v. Commissioner,
T.C.M 2001-2 (2001), affirmed 10th Circuit (April 2002) the taxpayers converted
their former residence to rental property by renting it from September to
December for a few hundred dollars per month. In 1992, J. Clark and Mary
Bundren purchased a house in Tulsa, Oklahoma, as their residence. In 1994, they
converted it to a rental property and listed it for $134,500. In December 1994, the
Bundrens agreed to exchange their property with Ms. Youngblood for her 116th
East Avenue property. She paid the $134,500 price for their property plus
settlement charges. The Bundrens paid $67,500 price plus settlement charges. In
1996, the couple sold the 116th East Avenue property for $61,600 plus closing
costs of $10,668. The Bundrens did not report the gain or loss with respect to the
exchange on their 1994-1995 joint returns, but they claimed depreciation on the
116th East Avenue property in 1995 and claimed a $159,820 loss on the sale of the
property in 1996. The IRS determined that the couple’s adjusted basis in the 116th
East Avenue property after the exchange was $67,500 and the loss on the sale was
$13,406, rather than $147,206 and $159,820, respectively. The parties stipulated
that it was a like-kind exchange. At the time of the conversion, the taxpayer’s
basis in the relinquished property is the lesser of fair market value or adjusted cost
basis. (See Treas. Reg. §1.165-9(b)(2).)
The Tax Court determined the couple’s carryover basis in the Tulsa property, first
noting that $134,500 was the price for the Tulsa house in the like-kind exchange.
The court observed that the couple presented no credible evidence for a higher
basis and held that the carryover basis was $134,500. The court next considered
what boot the couple received in the exchange. The court, noting that the couple
computed the basis of the Tulsa property by treating $70,244 as boot, held that
they conceded receiving boot. The court determined that the couple received
$67,000 as boot, and it held that their adjusted basis in the Tulsa property was
$78,168.
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