Last month, the Minnesota Tax Court issued a decision in Johnson v. Commissioner of Revenue, No. 8544–R, 2014 WL 2965410 (Minn. T.C. June 20, 2014), with respect to taxpayers’ exchange of unimproved land for a two-bedroom condominium. Johnson is a ruling of significance for taxpayers hoping to take advantage of Section 1031 of the Internal Revenue Code (“Section 1031”) as it may apply to their state taxes.
Section 1031 allows taxpayers to defer recognition of the gain or loss “on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” IRC § 1031(a)(1). There are several requirements that must be met in order to qualify for Section 1031 exchange treatment, including certain timing and character of property conditions. With the complexities of Section 1031 in mind, a summary of the background of Johnson follows along with a synopsis of the taxpayers’ arguments and the court’s findings. This article concludes with some lessons which can be taken from Johnson.
Taxpayers Richard and Glenna Johnson are long-time real estate investors, particularly in bare land in Idaho. Richard testified that there are significant advantages to owning bare land in Idaho, particularly: extremely low property taxes (“you end up paying $15 [in property taxes] on a $400,000 piece of land if its farmed”); low insurance (“the liability portion of the policy . . . on your home . . . covers any liability claims on the parcels of land out in Idaho.”); and low maintenance (“We didn’t need to have it supervised or looked after.”). It can be inferred from this case that generally, after one year, the Johnsons would sell one piece of bare land and exchange it for another piece of bare land in a transaction intended to qualify under Section 1031.
In this particular case, the Johnsons sold bare land in Ashton, Idaho in April 2007 at a gain of $144,372 through an intermediary and purchased a condominium in Driggs, Idaho in July 2007.
Several days after the purchase of the condominium, the Johnsons’ adult son, Kristian, moved in and has resided there ever since. Kristian’s only payment to his parents was a one-time payment of $300. Other than a single deduction of $218 in 2007, the Johnsons never deducted any expenses or depreciation with respect to the condo.
The Johnsons did not include the gain of sale of the land in Ashton in their 2007 Minnesota taxable income. In 2011, the Minnesota Revenue Commissioner adjusted the Johnsons’ 2007 income to include the gain on the sales of Ashton land, denied the $218 deduction related to the condo and assessed the Johnsons $10,272 in additional tax, plus penalties and interest.
OPINION AND TAXPAYER ARGUMENTS
The parties in Johnson did not dispute that the timing of the Johnsons’ purchase of the condominium satisfied the timing requirements of Section 1031. The parties also did not dispute that the bare land and the condominium are like-kind within the meaning of Section 1031. The only item in dispute is whether the Johnsons hold the Driggs condominium as an investment.
Revenue Procedure 2005-14, § 2.05 provides that “[S]ection 1031 does not apply to property that is used solely as a personal residence.” 2005-1 CB 528. Under Code Section 280A(d)(2)(A), a taxpayer’s family member’s use can qualify a property as being used as a personal residence. The court then found that “Kristian’s use of the condominium as his personal residence, without payment of rent, disqualifies the property from [Section 1031 treatment].”
The Johnsons contended that their intent at the time of the purchase of the condominium is controlling in determining their intent for the property for Section 1031 purposes, with which the court agreed. This intent is crucial to the determination of whether property is an investment or otherwise. However, the court did not agree that the Johnsons intended use of the condo was as an investment, as their son moved into the property only a few days after its purchase. The court determined that the evidence indicated that the Johnsons “knew” that they were not purchasing the condo for investment purposes.
Finally, the Johnsons argued that “because the IRS has not challenged their treatment of the transaction, the [Minnesota Revenue] Commissioner is barred from doing so.” The court found that the IRS’ failure to audit the Johnsons’ federal return is no indication of the IRS’ approval of the Johnsons’ characterization of the transaction. Further, the court indicated that even if the IRS had investigated the transaction, the Minnesota Revenue Commissioner is not barred from its own investigation of the taxpayer.
Ultimately, the court found for the Commissioner and denied Section 1031 treatment to the Johnsons’ sale of the Ashton land. The court also affirmed the Commissioner’s addition of penalties and interest to the Commissioner’s assessment.
LESSONS FROM JOHNSON
Johnson is demonstrative of several important tax planning lessons.
- Knowledge of federal tax law is imperative to properly reporting state tax liability, because most states adopt the majority of the Code in arriving at adjusted gross income or taxable revenue for state tax purposes. As such, transactions may not only need to pass IRS muster, but also review of the state taxing authorities.
- Even if the IRS makes a favorable determination, this determination may not thwart state tax challenges to the same transaction (not the case in Johnson, but the court indicated that this circumstance may occur).
- It is important to provide your tax counsel with all relevant facts. If the Johnsons told their tax counsel (assuming, arguendo, that they had counsel) that they (a) intended that the son move into the condo, or (b) that they decided after they bought the condo to let their son live there, their tax counsel could have better assisted them in structuring the transaction and filing their Minnesota tax return.
- Related to item 3, the state taxing authorities and the IRS generally have the benefit of hindsight. If a change of fact occurs after a transaction, contemporaneous documentation may be the most prudent way for a taxpayer to protect him or herself.