Case of the Week

Case:

Karl was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turn to gold. By far, Karl’s passion was real estate and he was very successful in his investments.

Karl continued to buy and sell real estate at the age of 85. His most favored tax strategy for buying and selling real estate revolved around IRC Sec. 1031. In short, Sec. 1031 allows taxpayers to exchange “like-kind” investment property without the recognition of gain or loss. This tax code section does not exclude the recognition of gross income indefinitely but merely defers the recognition to a later date.

Karl currently owns a $2 million building that has significant appreciation. He acquired the building pursuant to a Sec. 1031 exchange. In fact, this building is his fifth Sec. 1031 building. Like many real estate investors, Karl just kept “trading up” over the years. As a result, Karl’s basis in his $2 million building is extremely low.

Karl decided he wanted to sell the building, but he did not want to pay the “ticking tax time bomb.” In addition, he did not want do another 1031 exchange because he decided he was ready to retire from the real estate investment business.

Around this time, Karl learned of the benefits of a FLIP CRUT (e.g., income tax deduction, bypass of capital gain and future income stream). He especially liked the fact the FLIP CRUT could simply invest in stocks and bonds, which was something a Sec. 1031 exchange would not allow. Thus, after Karl learned about the benefits of a FLIP CRUT, he eagerly wanted to move forward.

Question:

It looked like the perfect solution. However, Karl did have one concern. Specifically, he acquired his building via a Sec. 1031 exchange from an unrelated party just nine months ago. Therefore, Karl wonders if there is any required holding period before he could dispose of his Sec. 1031 property into a FLIP CRUT?

Solution:

Karl’s question revolves around the holding period – or lack thereof – for a Sec. 1031 property. At present, there is no Code provision or regulation requiring any specific holding period for transactions between unrelated parties. However, the IRS has successfully challenged Sec. 1031 exchange property sales based on an "intent to sell" argument.

To qualify for Sec. 1031 benefits, you must have an "intent to hold" the Sec. 1031 property. But, if the IRS can show through the facts and circumstances that a taxpayer never intended to hold, but instead intended to sell, then he or she will likely lose. For example, the IRS may challenge a situation whereby a taxpayer performs a Sec. 1031 exchange and then immediately sells or disposes of the exchanged property two weeks later.

To best defend against an IRS challenge, most advisors suggest holding Sec. 1031 property for at least one year and treating Sec. 1031 property as investment property on the taxpayer’s tax return for that period. Under those facts, it is unlikely the IRS could successfully argue that the taxpayer had an “intent to sell.” Of course, a taxpayer can sell, gift or transfer Sec. 1031 property held for less than a year. The one-year suggestion is not an absolute rule but merely a guideline. However, the shorter the period, the more the risk grows.

In this case, Karl has owned the building for nine months and treated the building as investment property on his income tax return. While not meeting the generally suggested one-year holding period, Karl’s facts and circumstances were strong, and there was no evidence of an "intent to sell” at the time of the Sec. 1031 exchange nine months prior. Based upon this information, Karl decided to create a FLIP CRUT this year and fund it with his building. Once funded, Karl will immediately enjoy the many benefits that will flow from his FLIP CRUT, including the bypass of capital gain income from the unitrust’s sale of the building.