Diligence required in property use conversions regarding 1031 exchange eligibility
Q: What’s the first priority in converting properties held for sale or development to properties held for 1031 eligibility, that is, investment or appreciation?
A: Deed the properties over into new entities. Once deeded, there’s obviously a strong argument that a new use has occurred. But before you do this, get confirmation from your accountant that the deeding over from the current entity to a new one(s) won’t constitute an adverse, taxable triggering event.
Q: Why can a deeding procedure possibly require more diligence to ensure 1031 eligibility?
A: There’s an IRS case where a developer for 12 years held property mostly for sale and development. But there were a few lots the developer held for investment and appreciation. The IRS later didn’t believe this intent, and the case went to tax court. The IRS attorney asked the developer exactly when the few lots had been switched into investment and appreciation purposes, and the developer was speechless. That’s why it’s important to combine a deeding over strategy with some additional due diligence.
Q: So what more should be done, or what should you do if it’s not possible, or desirable, to deed over properties into new entities?
A: Three things: Take the properties off the market, including “for sale” signs, industry journals and online; change the intent to the public, by sending emails to your attorney, your accountant, your friends and your brokerage/listing partners that the property’s use is, as of a certain date, being changed from being held for development and sale to investment and appreciation; and communicate the change to your accountant or bookkeeper. Unless the actual way the properties are handled/treated on the accounting books is actually changed, there’s still a huge opportunity for your 1031 Exchange to be contested.