Today I read an article on Forbes.com by an excellent 1031 resource Peter J. Reilly. Peter’s article explained how a Minnesota taxpayer exchanged raw land for a condo in Idaho. When the Minnesota tax department reviewed the transaction 4 years later they discovered that the taxpayer’s son had been living in the condo after the purchase, paying only nominal rent. The exchange was thrown out, and the taxes on over $140K of gain became due.
The taxpayer argued that since the IRS did not question the exchange (they didn’t audit his return) that the exchange should be valid. He also argued that since this was not “raw land” the investment property needed someone to “look out” for it.
Minnesota was having nothing to do with either argument.
There are two lessons to this situation. The first is that there are very specific rules, in fact a safe harbor in Rev Proc 2008-16 that outline how a residential investment property can qualify for Section 1031 treatment. We make sure that our exchangors fully understand these rules when discussing their exchanges with them.
The second is that each state reviews Section 1031 exchanges differently. One thing has become very obvious based on our experience and comments made by Peter in his article. The states are closely examining all avenues for raising revenue. Most are cash strapped. To date, Pennsylvania is the only state that does not recognize 1031, so the code is a gift from the FEDS and the other 49 states. However, and this is what we explain to our Exchangors, you have to follow the 1031 rules to the letter or you run the risk of your transaction being rejected.
Do the states and the FED communicate on these transactions. Your guess is as good as mine. But, if you follow the rules, you don’t have to worry about that at all, do you?