Category: Partnerships & LLCs; Real Estate; Nontaxable
Exchanges Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com I refer to your memorandum of April 7, 1997 and our telephone conversation of the same day. Background The original property was relinquished on October 31, 1994, and the replacement property was acquired on January 25, 1995. The taxpayer rented the property during most of 1995 only occupying the house as his principal residence at the end of 1995. Section 1031, Partnership Context For tax purposes a partnership is sometimes viewed as an entity (the entity theory); while at other times, a partnership is viewed as an aggregate of its partners (the aggregate theory). In general, if a partnership-level act (such as receipt of exchange property) could potentially affect the partners' distributive shares of partnership income, it is necessary to use the entity theory. In this case, I feel that the entity theory is appropriate and necessary with respect to Section 1031 exchanges. It is clear for purposes of replacing property under the involuntary conversion rules of Section 1033 that the partnership, not a partner, must make the election and actually replace the property. Obviously, this is an example of the entity theory at work. See Demirjian v. Comr., 457 F. 2d. 1, 1972-1 USTC ¶9281 (3d Cir., 1097); and Revenue Ruling 66-191, 1966-2 CB 300. While it is true that there are some obvious differences between Sections 1033 and 1031, in my opinion existence of these strong precedents under Section 1033 bolsters the entity-theory conclusion with respect to Section 1031. It is essential in this matter to determine how the property given up in the exchange was actually held; however, it is necessary to look beyond mere title to determine whether the property in question was partnership property. It is my understanding that under the laws of some states, a partnership cannot hold title to real property. The same aggregate-theory-versus-entity-theory conflict exists for purposes of local property law. If local law views a partnership as an aggregate of its owners, a partnership typically cannot hold title to property. If, on the other hand, local law views a partnership as an entity, property can typically be titled in the name of the partnership. I am not an attorney. This matter should be pursued with an attorney competent to deal with Wisconsin property law issues. It seems to me that the starting point in this determination is to find out whether a partnership return was filed and whether the property in question has been reported to the IRS as a partnership asset. Even if you find that the property was titled in the name of the individuals, the property could still be partnership property if the state in question views partnerships under the aggregate theory. If you ultimately find that the property exchanged in 1994 was indeed partnership property, I feel that the Section 1031 exchange was invalid. Section 1031, Change of Intent for Replacement Property Under Section 1031, property held for investment or for use in a trade or business can be exchanged tax-free for similar property to be held for investment or to be used in a trade or business. On the surface, the taxpayer has met the literal requirements of the statute: the property received in the exchange was indeed held for investment for a matter of a few months. The obvious question is whether conversion of the property from investment to personal use so soon after the exchange jeopardizes the availability of Section 1031. It seems clear that what matters is the taxpayer's intent with respect to the property received in the exchange at the time of the transaction (i.e., in October of 1994). There are numerous cases dealing with the consequences of taxpayer dispositions of property received in a purported Section 1031 exchange. The courts have resolved those cases by looking at what the taxpayer intended to do with the exchange property at the time of the exchange. Accordingly, this matter should turn on whether the taxpayer intended to hold the Arizona property for investment at the time of the exchange. Obviously for any of this to matter, the taxpayer must be able to prove his intentions, whatever they were. In this particular instance, there are two alternative dates on which to gauge the taxpayer's intentions: the date of the original exchange (October 31, 1994) and the date on which the Arizona property was identified as the exchange property (November 14, 1995). There is an indication in the various cases that the taxpayer's intentions must be viewed on the date of the exchange. On the other hand, it should be noted that non-simultaneous exchanges came into common use after some of these cases were heard. For that reason, it is not 100% clear in my mind which date should be used. Given the closeness of the two dates in this matter, however, this point will hopefully be moot. The principal cases are Fred Wagensen v. Cmr., 74 TC 653; and Dollie Click v. Cmr., 78 TC 225. In Wagensen, the Tax Court upheld a Section 1031 transaction in which the taxpayer received exchange property and gave the property to his son nine months later. The court was heavily influenced by the fact that the father did indeed hold the property for investment during the nine months prior to the gift, and the son held the property for investment after receiving the gift. In contrast, the Click court held against Section 1031 treatment where the taxpayer exchanged a farm for two residences which she gave to her children some seven months after the exchange. During the taxpayer's seven-month holding period, the children lived in the residences, made improvements to the residences, and purchased homeowner's insurance for the residences. The court found that the taxpayer had acquired the residences with the intention of giving them to her children. As I understand it, the taxpayer in this case intended at the outset to hold the Arizona property for investment, an intent which manifested itself in his successfully renting the property for a number of months after first receiving it. Obviously, the fact that the taxpayer did actually rent the property is greatly in his favor. I further understand that the taxpayer intended to retire in Arizona at some point in the future, and I assume that it would be fair to say that the taxpayer possibly intended to occupy the property as his residence someday. It seems to me the mere possibility that the taxpayer could convert the property from investment to personal use at some point in the future should not be fatal to Section 1031; however, the fact that the conversion occurred so quickly casts doubt back to the taxpayer's initial intentions. Ultimately, I believe this matter should be decided based on which of following two alternative sets of facts is found to be the more convincing. A) Did the taxpayer intend from the outset to use the property for personal purposes, and the rental was merely a device to defray his holding costs while he settled his affairs in Wisconsin and moved to Arizona? OR ALTERNATIVELY... B) Did the taxpayer intend from the outset to hold the property for investment and his intentions with respect to the property unexpectedly changed? Based on the facts you outlined to me, I think the taxpayer has a fairly good chance of supporting the latter fact pattern. As I understand it, the taxpayer was unexpectedly offered a job in Arizona shortly after he received the exchange property. Bearing in mind that the original exchange occurred on October 31, 1994 and the Arizona property was identified as the exchange property on November 15, 1994, I suggest putting the following questions to the taxpayer. When was the taxpayer's first contact with the Arizona employer? When was the job offer actually made? Did the taxpayer seek out the Arizona job or was the offer unsolicited? If the Arizona job was the result of a job search, when did the job search begin? If the Arizona job was the result of a job search, did the taxpayer seek positions in other localities as well? Obviously, it would be best if the taxpayer did not seek out the Arizona job, and the first contact was made with the employer some time after November 15, 1994. On the other hand, if the taxpayer previously knew about the job, I would be reluctant to treat this transaction as a valid Section 1031 exchange. I invite you to put these questions to the taxpayer and then contact me to discuss his responses and their ramifications.
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