Archive for April 24th, 2012

Mixing family and business is never a good idea. Working closely with someone you’re intertwined with on multiple levels is sure to lead to personality conflicts, financial squabbles, and in the case of Patrick and Michael Reesnick, the occasional attempted poisoning.

In 1985, Patrick Reesnick and his brother purchased an apartment building as tenants in common, and as the Tax Court put it, “that concludes our record of civil behavior between the two brothers.” Michael Reesnick accused Patrick of leaving him “holding the bag while he went out to have a fancy time,” while Patrick countered by claiming that Michael had stolen money from him and yes, “poured cleaning fluid into his drinking water.” Brotherly love at its finest.

The inevitable lawsuit ensued, and the brothers were ordered to sell the apartment building, which they did in September 2005. Rather than immediately recognize his share of the resulting gain, however, Michael Reesnick sought deferral under the “like-kind exchange” provisions of Section 1031.

As a reminder, Section 1031 provides that no gain or loss is recognized on the exchange of property held for use in a trade or business or for investment if the property is exchanged solely for property of a like kind that is also held for use in a trade or business or for investment.

In November 2005 — within the prescribed time limits of I.R.C. § 1031(a)(3) and Treas. Reg. §1.1031(k)-1(b)[1] for a good exchange–  Reesnick acquired a replacement property in the Lake Tahoe area. The property was a home that Reesnick intended to hold as a rental. He took the following steps in an attempt to find a tenant:

  • Posted flyers on the home and in the surrounding neighborhoods advertising the rental;
  • Met with potential renters; and
  • Worked with a realtor to set the rental rate.

Despite these efforts, Reesnick was unable to find a tenant, and the home was never rented. Soon after the acquisition of the rental property, Reesnick found his financial obligations mounting, and with three properties on his personal balance sheet, something had to give.

In April 2006, Reesnick succeeded in convincing his wife to put their primary residence up for sale to free up some cash, and move into the vacant Tahoe replacement property.[2] As a result, just six months after the exchange was completed, the Reesnicks made the Tahoe home their primary residence.

As a result, the IRS disallowed the deferral of gain on Reesnick’s 2005 sale of the apartment building, arguing that a like-kind exchange did not occur because Reesnick failed to hold the Tahoe property for use in a trade or business or for investment, since 1) it was never rented, and 2) it became the Reesnick’s primary residence soon after the exchange.

In ruling against the IRS and holding that the exchange qualified for deferral under Section 1031, the Tax Court concluded that Reesnick’s intent for acquiring the replacement property must be determined at the date of replacement. Differentiating Reesnick’s facts from previous decisions, the Tax Court noted that the following factors favored the finding of a good exchange:

  • Reesnick’s repeated attempts to rent the replacement property;
  • The lack of personal use during the purported “rental period;”
  • Prospective tenants testified that they visited the property with the intention of renting it, but could not afford the asking price; and
  • Mrs. Reesnick’s testimony that she never discussed moving into the Tahoe property until after the exchange had been completed.

Lastly, Reesnick’s own brother — intending to testify for the IRS — made up for his bouts of attempted murder and inadvertently blessed the exchange by stating that Reesnick had told him on several occasions that he would never move into the Tahoe house until his kids were out of high school. Because Reesnick’s oldest son had not yet graduated at the time of the exchange, the court saw this as evidence that Reesnick’s intent at the time of the exchange was to hold the property for investment.

It should be noted, in 2008 the IRS published Revenue Procedure 2008-16, which clarified the Service’s position on like-kind exchanges where the replacement property eventually becomes the taxpayer’s primary residence. In the Procedure, the IRS provides a safe harbor for exchanges entered into after March 2008 that covers situations exactly like the one in Reesnick where a taxpayer enters into an exchange in which the replacement property is a dwelling unit. The IRS clarifies that they will not challenge the Section 1031 exchange as long as the replacement property:

  • 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.

Keep in mind, this is merely a safe harbor, and exchanges falling outside the safe harbor — as the Reesnick’s would have courtesy of their failure to rent the property — may still be held to represent valid exchanges under a facts and circumstances test.

[1] i.e., the 45 and 180 day limits on identification and replacement

[2] I use the word “convince” because Miss Reesnick had previously threatening to leave her husband if he made her leave their previous residence.

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