121 and 1031

In Uncategorized on 01/25/2013 at 23:17

I was so absorbed by Judge Wherry’s 114-page excursion through the wilderness of Nevada and appraisal practice yesterday (1/24/13), Estate of Shirley Giovacchini et al., 2013 T. C. Memo. 27, that I almost forgot Judge Goeke’s foray into similar territory on that same day, Jessie G. Yates III and Melissa Long Yates, 2013 T. C. Memo. 28, filed 1/24/13.

Although Judge Goeke has much to say about appraisals, we’re back to the Alice in Wonderland story of eating the cake that makes one smaller and imbibing the drink that makes one larger; but this time we have a principal residence and a business property transferred at the same time.

Jess and Mel had a home and a restaurant (the Hula Grill). They sold their home and bought a vacant lot, on which they built a house. They claimed they wanted to use the new house as a bed and breakfast, and included a statement to that effect in their purchase contract, but never checked the zoning or required their seller to obtain any permits or approvals, or conditioned their performance on obtaining same.

But they did move in and live there.

Next, the Hula Grill almost lost its grass skirt when their neighbor, Mr. Maynard, a seasoned real estate investor doing an assemblage for a Hilton hotel, terminated their lease on an adjoining lot, whereon Jess and Mel parked the cars of the Hula Grill diners. Without a parking lot, the Hula Grill was toast.

So Jess and Mel sold to Maynard, insisting he had to buy the new house as well as the Hula Grill. Jess and Mel wanted to do a Section 1031 like-kind exchange, wherein like for like can be swapped tax-free; but a Section 1031 exchange only works for property used in a trade or business, or held for investment.

Jess and Mel strike out on the new house as business property. Their testimony is self-serving, and the contract reference to a bed and breakfast is window-dressing, says Judge Goeke. See my blogpost “Welcome, Judge Guy”, 4/24/12, wherein I skim over the Reesink case, cited by Judge Geoke.

Now as to the Section 121 exclusion of gain on sale of principal residence. IRS agrees the new house was Jess’ and Mel’s principal residence. Since the new house is a principal residence, and Jess and Mel can satisfy the various two-out-of-five rules, they can exclude $500K of gain even if they can’t get Section 1031 benefit.

Judge Goeke: “Consequently, we are presented with the simultaneous application of section 121 and section 1031 to the exchange at issue. The Commissioner has indicated that in these circumstances ‘[s]ection 121 must be applied to gain realized before applying section 1031’. Rev. Proc. 2005- 14, sec. 4.02, 2005-1 C.B. 528, 529.” 2013 T. C. Memo. 28, at p. 5.

So each of the two properties sold must be treated as a separate exchange group, the Hula Grill as like-kind, and the new house as “boot” or unlike-kind. Jess and Mel spell out the relative values of the two properties in the contract, and Mr. Maynard, the real estate pro, initials the allocation and signs off. He isn’t doing a Section 1031 exchange; for him, it’s a straight purchase.

IRS claims Jess and Mel gerrymandered the allocation, to minimize the value of the Hula Grill property so as to sop up the gain from the new house. IRS also wants substantial undervaluation penalty.

No, says Judge Goeke. While the new house isn’t like-kind, the fact that the sale to Mr. Maynard was arms’-length, and adversarial; Maynard had shut down the Hula Grill and didn’t want the house. Maynard was doing a purchase, not an exchange.  Maynard testified he didn’t remember how the allocation came about, but Judge Goeke opines that, as a sophisticated real estate operator, Maynard would be expected to make sure each of the properties he bought would have basis appropriate for disposition or depreciation.

And since Jess and Mel cooperated with IRS, and since the agreement with Maynard was some evidence of an arms’-length valuation of the properties, IRS had Section 7491 burden of proof here, and IRS fails to discharge that burden.

So the allocation stands, and there’ll have to be a Rule 155 hoe-down to see how the numbers work.

But Jess and Mel may have a Section 6662 penalty, since they don’t put their accountant on the stand or provide either the accountant’s credentials, or what they told their accountant, or what their accountant told them.

Takeaway- Always, always put the preparer and advisor on the stand–if they have any credentials at all. See my blogpost “The Case of the Incoherent Accountant”, 3/1/11.

  1. I seem to be missing something. The T/P’s we selling the Hula Grill, and insisted that the buyer buy their home, so what were they buying in the 1031 exchange? Or was this action a prelude to buying another property, undisclosed, within the alloted time?


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