Originally published on Forbes.com July 23rd, 2014
The like-kind exchange (Code Section 1031) is one of the most powerful non-recognition provisions. Although it is applicable to many types of property, it is particularly valuable in real estate, since all real estate in the United States is like-kind to all other real estate. Thus when Richard and Genna Johnson sold a 20-acre parcel of bare land in Ashton, Idaho, it was, OK, in principle, for them to exchange for a condominium in Driggs, Idaho. Unfortunately, there is another more overarching rule, that they neglected causing the Minnesota Tax Court to agree with the Commissioner of Revenues forcing them to recognize the $144,372 gain from the bare land. (Sorry, cannot find a free link to the decision).
The rule that they ran afoul of is that both the relinquished property and the target property must be used in a trade or business or held for investment. Although they argued that they met the rule on both properties, the Commissioner thought they came up short on the condominium. Here is the story, so you can be the judge.
Investing In Bare Land
Mr. Johnson testified as to how easy it was to invest in bare land in Idaho:
One is there are almost no taxes. Out in Idaho they give a huge advantage to the person who their land is unimproved and they lease out the land maybe for cropping. It’s enormous. Much different than here. And so you end up paying $15 on a $400,000 piece of land if it’s farmed. That’s one advantage. The other advantage is that the insurance that you normally have on an improved home is not there on a piece of bare land because under law, our law anyway, the liability portion of the policy that you have on your home, whether it’s back here or someplace else, covers any liability claims on those parcels of land out in Idaho. So we didn’t even have to carry a liability insurance policy. Literally there were no expenses involved. We didn’t need to have it supervised or looked after. You simply held onto it for the required year and then you could sell it. And the market was such out there that usually that’s what we did. After a short period after a year, we would put it on the market and reinvest it in land out there.
Condos Are Different
Investing in a condo was a different story. It requires a person to “look after it”. Make sure the furnace is on so the pipes don’t freeze and things like that.
As it turned out, the Johnsons not long after they bought the condo found that their son needed a place to live. Since they happened to have this condo that needed looking after it, it was something of a “win-win” to have him move in. He never paid more than nominal rent and the Johnsons maintained that their intent was to profit from appreciation on the condo. That intent they argued was all that mattered when it came to qualifying as a 1031 target.
The state revenue department and the Minnesota Tax Court were not buying it.
We agree that the taxpayer’s intent under section 1031 is determined as of the time of the exchange.
But evidence of events occurring after the Johnsons’ purchase of the condominium is nevertheless relevant. Indeed, courts routinely consider evidence of events occurring after purchase.
Moreover, to qualify a residence as an investment requires more than the hope that it will appreciate in value.
It would be interesting to run the numbers and see how things might have hypothetically worked out if the Johnsons had given their son enough money to pay a reasonable rent. There is not enough information in the case to do that exercise and I lack the patience but don’t let it deter you if want to try. Keep in mind that there would not be much in the way of depreciation, since the deferred gain reduces basis in the replacement property.
Unscrambling An Egg
The other argument that the Johnsons had was that Minnesota follows federal income and since the IRS did not object to the exchange, Minnesota should follow along. The Court did not find that argument persuasive.
The Johnsons further suggest that because the IRS has not challenged their treatment of the transaction, the Commissioner is barred from doing so. We disagree. We do not equate the IRS’ failure (thus far) to audit the Johnsons’ 2007 federal income tax return to its approval (tacit or otherwise) of the Johnsons’ treatment of the transaction. Moreover, Minn. Stat. § 270C.03, subd. 1(2) (2012), specifically authorizes the Commissioner to “make determinations, corrections, and assessments with respect to taxes, including interest, additions to taxes, and assessable penalties.” The Commissioner is not barred from assessing the Johnsons here. ……… the Commissioner can adjust a taxpayer’s gross income based upon the Commissioner’s own independent investigation of the taxpayer).
I believe most, if not all, states with income taxes will more or less automatically ding you if the IRS adjusts your return. I don’t know of an automatic procedure working the other way, though. So it seems likely that the Johnsons “got away” with the exchange for federal purposes. Since it was a 2007 transaction, they are probably by even a six year statute (which probably would not apply if they reported the exchange on Form 8824). So their basis in the condo is not reduced by a deferred gain for federal income tax purposes.
The interesting question that this creates is what happens with Minnesota when the condo is sold. According to the instructions to the Minnesota return there are no longer provisions for state/federal differences. So it is possible that Minnesota will get to tax them twice on the same gain. Thinking through the Idaho implications gives me a headache, so I won’t even mention that.
Are The States Doing The Job Of The IRS?
Something that the lovers of federalism who are gutting the IRS enforcement capacity might want to consider is the effect that it will have on states, which will be more inclined to initiate audits of issues that might have been handled federally. I’ve been noticing more of those cases. From an administrative viewpoint life would be easier, even for taxpayers, if there was only one agency that could make a determination about what your federal adjusted gross income is.
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