WHAT IS “INVESTMENT INTENT” IN A 1031 EXCHANGE? AND WHEN IS INVESTMENT INTENT MEASURED?

March 17, 2023
By: Julia Mastrotto, Esq., Counsel

Internal Revenue Code Section 1031(a) provides that “no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” In short, to qualify for a tax deferred 1031 exchange, the property must be held for investment.

Considering the effects of recent natural disasters, like Hurricane Ian and Nicole, and severe winter storms in California, the issue of investment intent has become a common concern amongst taxpayers who recently transacted a 1031 exchange and purchased replacement property that was affected by the disaster. What if I acquired my rental property 6 months ago, and the disaster destroyed or affected it such that I can no longer rent? What if I need to rebuild and reconstruct, and will not be able to rent again for a prolonged period? Will this create issues regarding the requisite 1031 “investment intent”? The common denominator for analyzing these situations is, at what point in the exchange/transaction and subsequent ownership period is investment intent measured?

In a nutshell – investment intent is measured at the time of acquisition of the replacement property. Therefore, where the requisite intent is satisfied for purposes of IRC Section 1031, it is unlikely that a delay or gap in rental activity resulting from a third-party action or act of nature outside of the taxpayer’s control will, by itself, invalidate the exchange.

It is notable that the locales affected by disasters like Hurricanes Ian, Fiona, and Nicole tend to have a higher percentage of residential vacation rentals than others. They are also areas where upon retirement, investors tend to convert a qualifying vacation rental into a property to be used predominantly as a primary or second residence. These facts, in conjunction with the 24-month holding period in Rev. Proc. 2008-16, may prompt concern amongst exchangers and their advisors. Will a gap in rental activity disqualify my replacement property from exchange treatment? Will I have to restart the rental process once the property is rehabbed? The law and guidance on intent seems to indicate that intent is measured on a case-by-case basis.

For guidance on these novel questions, we look to the Tax Court:

In Reesink v. Commissioner, a taxpayer transacted an exchange to purchase two replacement properties. The Tax Court looked to the facts of each exchange and for each, measured investment intent “at the time of the purchase.”^[1]The Court found that the taxpayers did not have the requisite investment intent with Property-1, but they did satisfy that requirement with Property-2.

Property-1: Taxpayers had made minimal efforts to rent the property and moved-in within two (2) months of acquiring it.

“The taxpayers’ only rental efforts consisted of placing a single advertisement in a neighborhood newspaper. Within two weeks of purchasing the property, the taxpayers began preparations to refinish the basement. The taxpayers subsequently moved into the replacement property within two months of acquiring it.”^[2]

Property-2: Taxpayers had attempted to rent the property but were unsuccessful. They opted to move into this property eight (8) months later and sell their primary residence when the taxpayers became concerned that they could no longer afford to maintain all three properties.

“[P]etitioners placed fliers throughout Guerneville, showed the [] property to potential renters, and waited almost eight months before moving in. . . . Furthermore, . . . petitioners made attempts to rent the [] property and refrained from using it for recreational purposes before moving in.”^[3]

Ultimately, the Tax Court found that investment intent is measured at the time of the exchange. Although for Property-2 the taxpayers were unsuccessful in renting, the Court found that they still had the requisite investment intent at the time that they purchased, despite moving into the property eight (8) months later.

In another Tax Court case, Johnson v. Comm’r of Revenue, the Court “agree[d] that the taxpayer’s intent under section 1031 is determined as of the time of the exchange.”^[4] In this case, the Court found that the property was not purchased with investment intent. Testimony showed that the taxpayers needed a place for their adult son to live, and that was the motivating factor for the exchange; they never intended to rent nor hold the property for business/investment purposes. The taxpayers made no effort to rent the property, instead they testified that their investment intent “was never more than the appreciation in its value.”^[5] Their son moved into the property one week after closing.^[6] It should be noted that absent a written rental agreement and payment of rent at fair market value, it is not permissive for taxpayers to rent an exchange property to a relative. To read more about renting a 1031 property to relatives, check out our article here.

It is widely known that for residences, holding the asset for mere appreciation in value is insufficient under Section 1031 to satisfy the intent element.

“Moreover, to qualify a residence as an investment requires more than the hope that it will appreciate in value. Moore, T.C. Memo. 2007-134, at *10 (“the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence”).”^[7]

It is far more acceptable for a taxpayer to purchase vacant or bare land for investment purposes (not a residence), with the intent that the land itself will appreciate in value.

“Although not explicitly stated at trial, ownership of a condominium also presumably required the Johnsons to purchase property insurance and to pay utilities and did not provide the Johnsons with the same property tax advantages available with respect to bare land.”^[8]

There are significant advantages to owning and holding bare land for appreciation and investment purposes, as opposed to a residence; it is these benefits that are considered in determining that holding a residence for mere appreciation is typically insufficient for the 1031 intent element.

Moreover, according to the Tax Court in Klarkowski v. Commissioner, a critical component is the passive appreciation of the property: “An ‘investor’ or speculator in real estate is usually anticipating a gradual appreciation in value of the real estate, or a rather sudden increase in value in the event of fortuitous circumstances, without his doing much to cause that increase in value; whereas the dealer in real estate is typically looking for a rapid increase in price over a relatively short time, most frequently as a result of some efforts on his part to cause the increase.”^[9] In Klarkowski, with respect to raw land acquired as a replacement property in an exchange by an individual, the Court noted several key factors that weighed against the exchanger’s position that they held the property for investment.^[10]

Please be advised that taxpayers who hold a property primarily for resale, like flippers, dealers, and/or wholesalers, do not qualify for 1031’s requisite investment intent. To read more about flippers and dealers in 1031 exchanges, check out our article here.

Considering the above, although all exchanges are evaluated on a case-by-case basis, it can be concluded with some certainty that investment intent is measured at the time of the exchange. Additionally, “in assessing a taxpayer’s intent at the time of the exchange, . . . the United States Tax Court routinely considers evidence of events and actions after the time of the exchange.”^[11]

It should be noted that under Rev. Proc. 2008-16, there is a safe harbor for dwelling units regarding whether they qualify under Section 1031 as properties held for investment or business intent (the “qualified use” requirement). This safe harbor sets a 24-month hold period:

The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and
Within the qualifying use period, in each of the two 12-month periods immediately after the exchange,
- The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
- The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

To read more about the “qualified use” safe harbor and the holding period, check out our articles:

Converting 1031 Property into a Property for Personal Use.
Can I 1031-Exchange My Vacation Home?

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[1] Reesink v. Commissioner, No. 2475-10, 2012 Tax Ct. Memo, at 1 (T.C. Apr. 23, 2012). See also Goolsby v. Comm’r, T.C. Memo 2010-64 (T.C. 2010). See also Danielson v. Comm’r of Revenue, 2013 Minn. Tax, 2013. See also Johnson v. Comm’r of Revenue, 2014 Minn. Tax, 2014.

[2] Reesink v. Commissioner, No. 2475-10, 2012 Tax Ct. Memo, at 15 (T.C. Apr. 23, 2012).

[3] Id. at 16.

[4] Johnson v. Comm’r of Revenue, 2014 Minn. Tax, 10, 2014. See also Click v. Comm’r of Internal Revenue, 78 T.C. 225, 231 (1982) (citing Land Dynamics v. Comm’r of Internal Revenue, T.C. Memo 1978-259, and Klarkowski v. Comm’r of Internal Revenue, T.C. Memo 1965-328).

[5] Johnson v. Comm’r of Revenue, 2014 Minn. Tax, 13, 2014.

[6] Id. at 5.

[7] Id. at 12.

[8] Id. at 5.

[9] Klarkowski v. Commissioner, Docket Nos. 3778-62 – 3780-62, 436-65 – 439-65, at 41 (T.C. Dec. 30, 1965).

[10] For example: the taxpayer relinquished income producing real estate in exchange for a tract of raw land that produced no income; at the time it was acquired, that land was part of a larger tract slated for development as a golf course; neither the individuals or the partnership involved in the transactions had no means of developing the golf course; and they were unable to carry the debt on a non-income producing property for a long period of time, which indicated a short-term holding plan.

[11] Danielson v. Comm’r of Revenue, 2013 Minn. Tax, 20-21, 2013. See, e.g., Reesink v. Comm’r, T.C. Memo, 2012-118 (T.C. 2012) (describing efforts made by the taxpayer to rent the property after the acquisition); Goolsby, T.C. Memo 2010-64 (describing the taxpayers’ use of the property after acquisition); Moore v. Comm’r, 93 T.C.M. (CCH) 1275, T.C. Memo 2007-134 (2007) (describing the taxpayers’ use of the property after the acquisition). We have similarly considered evidence of events and actions after the time of the exchange. See, e.g., Brooks v. Comm’r of Rev., Docket No. 8324 R, 2012 Minn. Tax (Minn. T.C. Apr. 20, 2012) (noting that real property claimed to have been acquired as rental property was not furnished for two years after acquisition and was not actually rented for nearly four years after acquisition).

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