Many property owners are aware that one can sell investment property, at a profit, and reinvest the sales proceeds in replacement investment property, without having to pay tax on the sale. Such transactions are known as "tax-deferred exchanges" or "1031 exchanges" (1031 being the Internal Revenue Code section that authorizes the transactions). Certain requirements must be satisfied, such as (in the case of a nonsimultaneous exchange) identifying the replacement property and acquiring the replacement property within specified time periods after the sale of the first investment property. The tax on the sale of the first investment property is essentially deferred, and is generally payable upon the subsequent sale of the replacement property.
The recent Tax Court cases of Reesink v. Commissioner and Adams v. Commissioner indicate that investment property can include property that is later converted into the owner's residence or that was previously the owner's residence.
In the Reesink case, Mr. Reesink and a relative sold a San Francisco apartment building for $1,400,000. Mr. Reesink made a profit of approximately $425,000. With the sale proceeds, he purchased a single-family home in Sonoma County, California, and attempted to locate renters for the Sonoma home. Some eight months later, after failing to rent out the Sonoma home, Mr. Reesink and his family moved into the home as their personal residence. Mr. Reesink did not pay tax on the profit from the sale of the San Francisco apartment building, claiming that the sale of the apartment building and purchase of the Sonoma home was a 1031 exchange. The IRS disagreed, asserting that Mr. Reesink purchased the Sonoma home not as replacement investment property, but with the intent to make it his personal residence. The Tax Court noted that Mr. Reesink had attempted to rent out the Sonoma home, concluded that it was purchased as investment property, and ruled in favor of Mr. Reesink. Notwithstanding the court's decision, many advisors may feel that an owner of replacement investment property should hold it as investment property for considerably more than eight months, to demonstrate investment intent, before converting it to the owner's personal residence. This view is based on various IRS private letter rulings (which are not legal precedent), which have approved a two-year holding period as demonstrating investment intent.
In the Adams case, Mr. Adams purchased a home in San Francisco for $26,000 and lived there for many years. He eventually moved to Sonoma County, California and rented his San Francisco home to a family friend. He continued to rent out the San Francisco home for a number of years until he sold it for $572,000. Mr. Adams reinvested the sale proceeds in a home in Eureka, California, which he rented to his son. Mr. Adams did not pay tax on the profit from the sale of the San Francisco home, claiming that the sale of the San Francisco home and purchase of the Eureka home was a 1031 exchange. The IRS disagreed, asserting that the rental arrangement between Mr. Adams and his son was in the nature of a gift, and the Eureka home was not investment property eligible for a 1031 exchange. The Tax Court noted that the son paid fair rental value for the Eureka home, concluded that it was purchased as investment property, and ruled in favor of Mr. Adams.
These cases tell us that investment property that qualified for a 1031 exchange can be converted into one's residence and that one's residence can be converted into investment property that qualifies for a 1031 exchange.