Do the tax file memorandum Taxpayer Information: Ted and Marvin Brown purchased

Question

Do the tax file memorandum

Taxpayer Information:

Ted and Marvin Brown purchased an apartment building in 2005 as equal tenants in common. After a hectic decade of co-ownership, the brothers determined that their business association should be terminated and decided to get rid of the apartment building. This led to a sale of the apartment building and a division of the proceeds.

The realized gain on the apartment building for each brother was $350,000. Ted planned to recognize the gain on his share and use the net proceeds to invest in stock. However, Marvin wanted to defer any recognized gain, so he had worked with a realtor to identify property that would be eligible for §1031 like-kind exchange treatment. The realtor identified a single-family home on Lake Tahoe that was currently being rented by the owner. Marvin agreed with the choice and worked through the realtor to acquire the single-family Lake Tahoe house in exchange for his share of the apartment building. Marvin deferred all of his realized gain.

After attempting to rent the Lake Tahoe house for eight months without success, Marvin concluded that he could not continue to make the mortgage payments on both his principal residence and this rental property. To ease his financial liquidity problem, Marvin sold his principal residence for a realized gain of $190,000 and moved into the Lake Tahoe house. He reported no recognized gain on the sale of his principal residence as the sale qualified for §121 exclusion treatment.

The Internal Revenue Service (IRS) issued a deficiency notice to Marvin associated with the exchange of the apartment building for the Lake Tahoe house. The position of the IRS was that Marvin did not hold the Lake Tahoe house for investment purposes as required by §1031 (the code section on like-kind exchanges). Instead, the IRS contended that Marvin’s intention was personal – to use the Lake Tahoe house as a replacement for his current residence that he planned on selling. Who should prevail?

Hint - you will find guidance from the following sources of tax authority:

Internal Revenue Code Section 1031. Be sure to cite this code section in the memorandum and explain relevant portions.

Once you have located this code section, search for tax regulations and/or court cases relevant to this issue. Be sure to cite and explain relevant sources in the memorandum. The following case may be helpful:

Patrick A. Reesink, 103 TCM 1647, T.C.Memo. 2012–118

Explanation / Answer

I believe that Marvin should prevail because I do not believe that those were his intentions when the like-kind exchange happened nor selling his personal residence and making his investment property into a personal residence.

First, Marvin did qualify for the 121 exclusion during the sale of his principal residence. The 121 exclusion allows homeowners to sell their primary residence and exclude from their taxable gross income of $250,000 in capital gains per homeowner. To qualify for the 121 exclusion, you must reside in this residence for at least two years during the five-year period as of the date of the sale, and in the question, is stated that he qualified for the 121 exclusion, so that means Marvin met the criteria. Marvin also made $190,000 off the sale of his personal residence which is less than 250,000 so he qualifies again.

As for the 1031, like-kind exchange, originally Marvin’s property was equally exchanged in that he got the house in Lake Tahoe for rental purposes, which would result in like-kind property because he was using it for investment purposes. At the time, that was his intent. However, after 8 months of not being able to rent the property out, he had to decide what to do and that was sell his personal residence. If he lives in this house on Lake Tahoe for 2 years or more of five years before he tries to sell the property (if he never does) then there was nothing wrong with what he did. At the time, his 1031 exchange was for like-kind property, and the sale of his personal residence qualified for the 121 exclusion. The only time he’d be subject to pay the deferral is if he tried selling the exchanged property before he owned it for five years.

So, Marvin should prevail.

https://www.irs.gov/irb/2005-07_IRB/ar10.html

http://www.atlas1031.com/blog/1031-exchange/bid/81461/Three-Issues-When-Converting-1031-Rental-to-Primary-Residence

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