Are you receiving tax free deferrals from 1031 exchanges? If your 1031 exchange gets audited by the Government the first question the IRS auditor will most likely ask you is--Do you hold your real estate for sale or do you hold your real estate for investment? How you answer this question and what evidence you have to support your answer may determine whether you win or lose the audit and whether your transfers will be taxable or tax free. Indeed, if you hold the property for investment you win but if you hold the property for sale you lose. So if you are involved in 1031 real estate exchanges, either forward, reverse or leaseback, and want to protect the tax free deferral of your gains, stay tuned to TaxView with Chris Moss CPA to learn how to structure your 1031 deals so can provide the evidence to the IRS you need to prove you own your real estate for investment and not for sale.
So what does “held for investment” (HFI) mean and how can you create the facts and evidence in your 1031 tax free exchanges to support the HFI best practice evidence needed to win an IRS HFI audit? Moreover, the definition of what constitutes HFI property is not easily found and neither the IRS Code nor the regulations define HFI. Neal Baker found out the hard way in Neal Baker v IRS US Tax Court (1998).
The facts were simple: Neal Baker Enterprises was a construction company incorporated in 1957 in California by Neal Baker. The company restructured in 1969 to acquire real estate for investment and development. In 1989 Baker sold some of the land that had been developed and reported on its corporate tax return 1120 a deferred nontaxable gain of $428,806 under Section 1031. The IRS audited and disallowed the tax free deferral claiming that the exchange did not qualify as a nontaxable exchange under Section 1031(a) because the real estate was primarily for sale and not HFI. Baker appealed to US Tax Court in Baker v IRS US Tax Court (1998) arguing that their original intent was to construct rental apartment units on the property in question and to hold to units for long term investment.
Judge Wright notes that the plan that Baker submitted to the County called for subdivision of the property into 48 lots for the construction of single family residential homes and would not have allowed for multi-family residential zoning. Baker claimed his intent changed years after the plans were submitted to the County. The Court agreed that “intent is subject to change” but only if there is written evidence, citing Cottle v IRS US Tax Court (1987).
The Court saw “no evidence of actions by Baker’s Board of Directors to corroborate Baker’s statement that he was no longer subdividing land.” The Court finds that Baker’s mere statements that his company intended to discontinue the development business are not enough to change the characterization of the Exchange Property, citing Tollis v IRS US Tax Court (1993). Indeed on each of its tax returns from years 1982-1991 Baker chose “real estate subdivider and developer” as its principal business activity on business tax form Form 1120 even though he could have chosen “real estate operator and lessor of buildings”. To make matters worse for Baker, the Government argued that Baker’s accounting records had recorded the Exchange Property as a fixed asset under “construction in progress”. Baker countered that the accountants were in error, but regrettably for Baker, the accountants never testified in court to explain, verify, or discuss why the real estate was classified incorrectly. IRS wins Baker Loses
What if you have a mix of HFI and for sale property as did Larry and Cynthia Beeler in Beeler v IRS US Tax Court (1997). The facts are relatively simple: the Beeler’s lived in Port Richey Florida and owned a mobile home park. In 1984 in order to expand their operations Beeler paid $766,000 for 76 acres of land next to the trailer park. Beeler also wanted to mine sand if they could obtain a County permit to do so. Beeler eventually obtained a mining permit in September of 1984 allowing them to extract 600,000 cubic yards of sand. But the application for the permit clearly stated that the primary purpose of the land purchase was to expand the mobile home park not to mine sand. Beeler claimed mining depletion deductions on their Schedule C on the personal 1040 tax returns from 1984 until the property was sold for $1.2 million in 1991 under Section 1031. On Beeler’s 1991 tax return the sale was reported on Form 4797 as a nontaxable transfer under Section 1031. The IRS audited and disallowed the Section 1031 tax free exchange claiming the sand was “property held for sale”. Beeler appealed to US Tax Court in Beeler v IRS US Tax Court (1997).
Judge Colvin quickly finds that while Beeler did mine the sand, mining was not their primary business as evidenced from the written application filed for the mining permit back in 1984. The Government countered that sand is inventory, not real estate, that sand on the property was worth $569,000 at the time of the sale and that at least that portion of the $1.2 million sales price should be taxable gain. But the Court again found again for Beeler in that sand was never mentioned in the sales contract. Beeler wins, IRS Loses.
So how can you bulletproof your tax return from an IRS Section 1031 HFI audit trap? First, if you are active in Section 1031 tax free exchange of real estate, be warned that to win a HFI IRS audit, you must have “contemporaneous” written evidence that your property was HFI over the entire duration of the Section 1031 exchange period. Second, if you alternate from year to year from being a landlord to a builder of multifamily rental units, or a developer of land into single family buildable lots, you must have “contemporaneous” evidence from your Board and your tax attorney to prove your 1031 property was HFI and not held for sale.. Finally, make sure each tax return filed during the 1031 exchange period contains written evidence in the return itself as to your HFI intentions. Years later during an IRS Section 1031 HFI audit you will be glad you did.
Thank you for joining us on TaxView with Chris Moss CPA.
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Chris Moss CPA