I. overview. A. Section 1031(a)(1) Requirements. Section 1031(a)(1) provides as follows




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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.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.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).

II.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 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).
(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.

(c)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.

5.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 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).

(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.

III.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 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 Rev. Proc. 2005-14, which are as follows:

(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.

(c)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.

5.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.


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 $470,000
Less: Adjusted Basis $190,000
Realized Gain $280,000
Less: Gain Excluded under §121 $250,000
Gain to be Deferred $ 30,000
(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].

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.
These results are illustrated as follows:
Total 2/3 Residential 1/3 Business
Property Property Property
Amount Realized $360,000 $240,000 $120,000
Basis $210,000 $140,000 $ 70,000
Depreciation Adjustment $ 30,000 $ 30,000
Adjusted Basis $180,000 $140,000 $ 40,000
Realized Gain $180,000 $100,000 $ 80,000
Gain Excluded
under §121 $100,000 $100,000
Gain Deferred
under §1031 $ 80,000 $ 80,000
(iii)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.
(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 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:
Total 2/3 Residential 1/3 Business
Property Property Property
Amount Realized $360,000 $240,000 $120,000
Basis $210,000 $140,000 $ 70,000
Depreciation Adjustment $ 30,000 $ 30,000
Adjusted Basis $180,000 $140,000 $ 40,000
Realized Gain $180,000 $100,000 $ 80,000
Gain Excluded
under §121 $150,000 $100,000 $ 50,000
Gain Deferred
under §1031 $ 30,000 $ 30,000
(iv)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. 2005-14].

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).
(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:
Total 2/3 Residential 1/3 Business
Property Property Property
Amount Realized $360,000 $240,000 $110,000 + $10,000
Basis $210,000 $140,000 $ 70,000
Depreciation Adjustment $ 30,000 $ 30,000
Adjusted Basis $180,000 $140,000 $ 40,000
Realized Gain $180,000 $100,000 $ 80,000
Gain Excluded
under §121 $150,000 $100,000 $ 50,000
Gain Deferred
under §1031 $ 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 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:
Total 2/3 Residential 1/3 Business
Property Property Property
Amount Realized $540,000 $360,000 $180,000
Basis $210,000 $140,000 $ 70,000
Depreciation Adjustment $ 30,000 $ 30,000
Adjusted Basis $180,000 $140,000 $ 40,000
Realized Gain $360,000 $220,000 $140,000
Gain Excluded
under §121 $250,000 $220,000 $ 30,000
Gain Deferred
under §1031 $110,000 $110,000
(iv)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 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:
Total 2/3 Residential 1/3 Business
Property Property Property
Amount Realized $750,000 $500,000 $250,000
Basis $210,000 $140,000 $ 70,000
Depreciation Adjustment $ 30,000 $ 30,000
Adjusted Basis $180,000 $140,000 $ 40,000
Realized Gain $570,000 $360,000 $210,000
Gain Excluded
under §121 $250,000 $250,000
Gain Deferred
under §1031 $210,000 $210,000
Gain Recognized $110,000 $110,000
(iv)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.

C.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.

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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