Can I Call My Replacement Property My Personal Residence & Investment?

1031 replacement property

Sometimes people want to do a 1031 Exchange into a property that they plan on immediately occupying as their home. As we've discussed before, they would have to treat the replacement property as either:

  • Business property,
  • Property used in my trade,
  • Or as investment property.

In this example, the exchangor hopes that the personal residence goes up in value. But is this considered an investment?

1031 Tax Court Case on 1031 Property Exchange of Lake Cabin

In a case called Moore vs. The Commissioner of Internal Revenue, a similar question was put before the tax court. A person was trying to do a 1031 Exchange from a second home lake cabin into a bigger, better second home lake cabin. The taxpayer in the case said, you know that this is a scarce commodity, and I anticipate that it will go up in value. I hope it goes up. The taxpayer was trying to make the argument that, even though it was his second home, his lake cabin that he never rented out, never advertised as a business property that it was still held for investment, so that it should qualify for 1031.

Hoping For an Increase In Value on Your Personal Use Property is not an Investment for 1031 Purposes

The tax court did not buy this argument. They said yes, everybody hopes that their primary residences and second homes go up in value. But, we really need to look at how you use the property to decipher what your intention was:

  1. Was your intention primarily to use the property for recreational and personal use or,
  2. Was your intention to hold it for investment?

These two intentions seem to be diametrically opposite to the IRS’s way of thinking (and their litigation position in the Moore case).

1031 Lesson Learned - Do Not Hold Primarily for Personal Use

Under the facts of the Moore case, the taxpayer was found to primarily hold the property for personal use…and the exchange failed. So, getting back to our question, Can I call my replacement property home/personal residence an investment, especially if I move into it immediately after I have completed my exchange? The answer is probably, no. That would probably not qualify because your use as your home is antithetical, completely opposite to use in one's business, use in one's trade, or holding for investment.

A Better Plan

Some taxpayers purchase replacement properties that they may one day move into, but for the first few years after completing their exchanges, they are careful to actually rent the replacement properties out for a substantial period of time to satisfy the requirements for their 1031 exchange. How long should they rent out their properties? The longer the better. 

It’s interesting that the rules for excluding your gain on the sale of your personal residence under IRC Section 121 have special requirements and allowances for properties that you previously 1031 like-kind exchanged into. It’s also interesting that the IRS has created safe harbors for replacement properties that are put into rental pools, and still allow the taxpayer to use the property on a limited basis for personal use.

  • 1031 Hotline: If you have questions about eventually converting your replacement property into a personal use type property in Minnesota, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

 

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