Tax

Why Two Identical 1031 Exchanges Had Opposite Outcomes in Tax Court

Earmark Team · August 13, 2025 ·

Two real estate investors. Two 1031 exchanges. Two family members moving into replacement properties. One investor successfully deferred taxes, while the other faced a costly audit that wiped out their claimed benefits entirely.

The difference wasn’t timing, family relationships, or even rental income. It was something far more subtle: the ability to prove genuine investment intent through documented business behavior that could withstand IRS scrutiny.

In Click v. Commissioner, the taxpayer’s relatives moved into the replacement properties the day after the exchange closed. Seven months later, she gifted both properties to those families. The Tax Court saw through what it called a sham transaction.

But in Adams v. Commissioner, when the taxpayer’s son moved into the replacement property and paid below-market rent, the court sided with the taxpayer. The exchange qualified despite the family connection and reduced rental income.

In a recent episode of the Tax in Action podcast, host Jeremy Wells broke down the 1031 fundamentals to explain why the transaction worked out for one taxpayer and not another. While Section 1031 exchanges offer real estate investors a powerful tool to defer capital gains taxes, success depends on more than following the rules. It requires proving genuine business intent through careful documentation.

Understanding the 1031 Exchange Foundation

Here’s what Section 1031 does: it allows you to exchange property held for productive use in a trade, business, or investment for like-kind property with the same intended use. But there’s a crucial point many miss: Section 1031 defers gain; it doesn’t eliminate it.

Wells explains, “There is a misconception out there among taxpayers who could use or want to use section 1031 exchanges that 1031 just eliminates the gain from a like-kind exchange.”

When you exchange one property for another, you don’t avoid taxes; you postpone them. The deferred gain carries forward, and the replacement property takes the same basis as the original property. Eventually, when you sell the replacement property in a taxable transaction, you’ll pay tax on both the original deferred gain and any subsequent appreciation.

Since the Tax Cuts and Jobs Act took effect in 2018, 1031 exchanges only work for real estate. But within that category, the definition of “like kind” is remarkably broad. You can exchange an apartment building for raw land, a commercial office building for a single-family rental, or developed property for agricultural land.

The key requirement is that both properties must be held for productive use in trade, business, or investment. You can’t use a 1031 exchange for your personal residence or vacation home that you use strictly for personal purposes.

The Intent Test That Trips Up Investors

The biggest challenge with 1031 exchanges isn’t the technical requirements; it’s proving you genuinely intended to hold the replacement property for investment or business use. Wells points out that this has become “a question of facts and circumstances that has to be determined at the time of the exchange itself.”

The courts have seen numerous attempts by taxpayers to use 1031 exchanges to defer gain on what were essentially personal property acquisitions disguised as investments. This leads to intensive scrutiny of taxpayer motivation, regardless of whether they follow all the mechanical rules correctly.

Consider the Moore v. Commissioner case. The taxpayers exchanged one vacation property for another, using both properties personally without any rental activity. When audited, they argued they held the properties for “investment,” meaning they expected the properties to appreciate in value.

The Tax Court disagreed. “Just the mere expectation of an increase in value is not sufficient to establish that investment intent,” Wells notes. Simply hoping property values will rise doesn’t qualify as holding property for investment under Section 1031.

This reveals how enforcement has evolved. Technical compliance with timing rules and intermediary requirements won’t protect you if your behavior contradicts your stated investment intent. The IRS looks at the complete picture surrounding each exchange.

What the Court Cases Reveal About Documentation

The contrast between successful and failed exchanges often comes down to documentation quality, not transaction structure. Let’s examine what separated the winners from the losers.

The Click Failure

The taxpayer exchanged her farm for two residential properties. Her children moved into those houses the day after the exchange closed. Seven months later, she gifted both properties to the families. Her defense crumbled because she couldn’t demonstrate any genuine rental activity during those seven months. The court saw this as a sham transaction designed to defer gain on personal property transfers.

The Adams Success

This taxpayer exchanged a rental property for a fixer-upper. His son moved in and began extensive renovations, living there during a three-month repair period in exchange for renovation work. After that, the father began charging rent. Yes, the rent was below market rate, and the son missed one payment. But the court saw a consistent pattern of business-like behavior: formal rental arrangements, regular cash payments, and documented property improvements.

The Goolsbee Disaster

These taxpayers placed a single advertisement in a neighborhood newsletter and moved into the replacement property within two months. When questioned during the audit, they couldn’t even answer whether rentals were allowed in their community. Their minimal marketing effort and inadequate preparation convinced the court that their investment intent was fabricated.

The Reesink Victory

Even though these taxpayers moved into their replacement property after eight months, they had a compelling record of genuine rental attempts: multiple flyers distributed around town, documented property showings to prospective tenants, and one potential renter who actually testified in court on their behalf.

Wells emphasizes the key insight: “It’s not necessarily a matter of waiting a certain number of months. It’s not a matter of whether you advertised that property for rent or not. It’s the culmination of all of these different facts and circumstances.”

The Technical Requirements You Must Follow

Beyond proving intent, you need to navigate specific compliance requirements that can make or break your exchange.

Timing Rules for Deferred Exchanges

Most 1031 exchanges today are deferred exchanges, where the sale and purchase don’t happen simultaneously. You have two critical deadlines:

45-day identification rule. You must identify replacement property within 45 days after closing on the sale of your original property. This identification must be in writing, signed, and sent to someone involved in the exchange.
180-day completion rule. You must receive the replacement property within 180 days of transferring the original property, or by the due date (including extensions) of your tax return for that year, whichever comes first.

Safe Harbor Requirements

The most common approach uses a qualified intermediary who holds the proceeds from your property sale and facilitates the replacement property purchase. The key is that you never have control of the funds from the original property sale.

Disqualified Persons

You can’t do exchanges with certain people, including your employees, attorneys, accountants, investment brokers, bankers, or real estate agents, if they’ve worked for you within the past two years. You also can’t exchange with close family members or entities where you own more than 10% of the stock or partnership interest.

Geographic Restrictions

You cannot exchange U.S. real estate for foreign real estate, or vice versa. Wells notes he’s “had to advise clients on this before because they want to start dabbling in rental markets outside the U.S.” or dispose of foreign properties to build their U.S. portfolio.

Reporting and Ongoing Obligations

Taxpayers must report successful 1031 exchanges on Form 8824, which has three main parts: property descriptions with key dates, related party disclosures (if applicable), and calculation of deferred gain and basis in the replacement property.

If your exchange involves related parties, you must file Form 8824 for two years after the exchange, and neither party can sell their received property during that two-year period without potentially disqualifying the exchange.

The replacement property continues the depreciation schedule from the original property. “Wherever we’re at in the depreciable life, the number of years of depreciation, the accumulated depreciation of the relinquished asset, we’re going to carry that over generally into the new asset,” Wells explains.

Building Your Defense Strategy

Enforcement of 1031 exchange rules has fundamentally shifted from checking compliance boxes to evaluating business narratives. Every marketing effort, tenant interaction, and business decision becomes part of a story that auditors may scrutinize for evidence of authentic business purpose.

When helping clients with 1031 exchanges, focus on creating documentation that demonstrates genuine investment intent:

Document all rental marketing efforts thoroughly
Maintain records of tenant interactions and property showings
Keep evidence of rental income and expenses
Avoid personal use that could undermine investment intent
Create a paper trail that supports your business purpose

A failed 1031 exchange can trigger penalties and interest that devastate investment returns. But when properly structured and documented, these exchanges provide real estate investors with a powerful tool for building wealth through tax-efficient property portfolios.

Wells’ comprehensive exploration provides the technical foundation every practitioner needs, but your ability to tell a compelling business story through consistent, credible evidence often matters more than perfect technical compliance.

For the complete technical framework and additional insights that can help you guide real estate investor clients through successful exchanges, listen to Wells’ full Tax in Action episode.

Why Tax Incentives Hurt More Than Help

Blake Oliver · August 29, 2024 ·

What if that mortgage interest deduction you’ve been counting on is actually making your dream home more expensive? Or if the tax credit for your child’s college tuition is secretly inflating their education costs? Welcome to the paradoxical world of well-intentioned tax policies, where good ideas often lead to unintended—and costly—consequences.

In a recent episode of The Earmark Podcast, I explored this issue with Scott Hodge, President Emeritus and Senior Policy Advisor at the Tax Foundation, a leading independent tax policy think tank.

Our conversation revealed how tax policy has a huge impact on everyone – both as professionals and as taxpayers. As Scott put it, “In so many ways our daily lives are ruled by taxes, whether it’s how we get our health care to the kind of house or car we buy, so many elements of our daily lives are wrapped up in taxes, whether we know it or not.”

As accounting and tax professionals, we must be aware of the hidden costs of well-intentioned tax policies in healthcare, housing, and education, where tax incentives can paradoxically drive up prices, ultimately harming the consumers they aim to help. This isn’t just an academic exercise—it’s a call to action for our profession.

The Paradox of Well-Intentioned Tax Policies

Let’s look at three areas where well-meaning tax incentives have led to unexpected and often counterproductive outcomes.

Consider the healthcare system. The way it operates today, with the majority of Americans receiving health insurance through their employers, stems from tax policies dating back to World War II. During this time, individual income taxes were very high. Employers found offering health benefits, which were not taxed, to be a more competitive way to compensate their employees. This paved the way for what is known as a “third-party payer system,” where healthcare providers are more answerable to insurance companies and employers rather than patients. The outcome? A disconnect between consumers and the actual cost of healthcare leads to a rise in medical expenses.

We see a similar paradox in the housing market with the mortgage interest deduction. Designed to make homeownership more accessible, it often has the opposite effect. Scott noted, “A lot of economic research shows that the mortgage interest deduction is built into the price of homes.” In competitive markets like Washington, New York, and California, this can make housing less affordable—the exact opposite of its intended purpose.

Perhaps most surprising is how tax incentives affect higher education. Those tuition tax credits we often recommend to clients? They might be padding university coffers more than easing student debt. Scott used a vivid analogy to illustrate.

“Imagine going to Best Buy to buy a television set,” Scott says. “And the sales clerk knows everything about your finances—how much your parents make, how much your house is worth, etc. They can price that television based on your finances, and you wouldn’t have a whole lot of negotiating power, would you?” This is essentially what happens when students apply to universities with tax credits in hand.

The Economic Theory Behind Tax Effects

Scott laid out a fundamental principle that explains why many tax incentives fall short: “If government’s trying to subsidize something or incentivize it, it’s the sellers of the good that tend to capture the value of that credit or deduction.”

Consider the electric vehicle tax credit, a hot topic in many client conversations. As Scott pointed out, “Obviously the automakers know what the value of that $7,500 credit is. And so they’re going to bake that into the price.” When advising clients on the potential savings of purchasing an electric vehicle, we need to consider that the sticker price may already reflect much of the tax credit’s value.

Conversely, when it comes to tax increases or tariffs, the burden typically falls on consumers. Scott explained, “Let’s say we were going to try to disincentivize imports so we increase tariffs by 10% across the board. Well, that’s going to get passed on to consumers through a 10% increase in prices across the board.” The takeaway? We need to be careful about using the tax code to incentivize and discourage behaviors because either way, we can see some unintended consequences.

Challenges of Tax Reform and the Role of Education

Given the paradoxes and economic principles we discussed, it’s clear that our current tax system often falls short of its intended goals. However, as Scott emphasized, “In order to get to tax reform, we’re going to have to do a lot of educating on the unintended consequences of these things.”

Scott outlined three key attitude changes needed for successful tax reform:

Taxpayers must be willing to give up credits and deductions for a simpler, more effective system.
Corporations should stop viewing tax departments as profit centers.
Lawmakers need to find better ways to deliver benefits than through the tax code.

These mindset shifts are challenging because they often go against ingrained habits and perceptions. Many struggle to understand the trade-off between higher tax rates with more deductions versus lower tax rates with fewer deductions. As Scott explained using the mortgage interest deduction example, “That mortgage interest deduction is a great thing for me. But I understand that it actually makes housing less affordable and less available for everyone. So maybe if we phased it out, we’d all be better off.”

This is where our role as educators becomes crucial. When a client comes to us excited about a new tax credit, we need to help them see the bigger picture. By consistently providing this kind of nuanced advice, we’re not just helping our clients make better decisions; we’re contributing to a more informed public discourse on tax policy.

By explaining how a seemingly beneficial tax credit might be “baked into the price” of goods or services, we can help shift the conversation toward more effective policy solutions.

The challenges of tax reform are significant, but so is our potential impact. We need to arm ourselves with in-depth knowledge and fresh perspectives to lead in this arena. That’s why I encourage you to listen to the full episode of the Earmark Podcast featuring Scott Hodge. You’ll gain valuable insights into the economic principles driving tax effects and practical strategies for advising clients on these complex issues.

Navigating the Ever-Changing Tax Landscape: Insights from Federal Tax Updates Podcast

Earmark Team · March 31, 2024 ·

In the fast-paced world of taxation, staying ahead of the curve is not just a matter of professional excellence; it’s a necessity for survival. The latest episode of Federal Tax Updates, hosted by Roger Harris and Annie Schwab, delves into the complexities of the current tax landscape, highlighting the challenges businesses and individuals face in staying informed and compliant.

Worker Classification: A Tightrope Walk

One of the most significant challenges in the current tax environment is navigating the intricacies of worker classification. With the Department of Labor (DOL) introducing a new six-factor test and the IRS maintaining its own rules, businesses must stay vigilant to avoid misclassification and its potential consequences.

As Roger Harris pointedly remarks, “We all understand the temptation and the belief that you can treat a worker as an independent contractor for 90 days until they work out. However, there’s no provision that allows for that.” This underscores the need for businesses to proactively understand and comply with worker classification rules to avoid penalties and legal issues.

COVID-19 Relief Measures: Staying Afloat in Uncharted Waters

The ongoing changes to COVID-19 relief measures, such as the Employee Retention Credit (ERC) and pending legislation, present another challenge for taxpayers. The moratorium on processing ERC claims and the voluntary program for those who may not qualify has created uncertainty for many businesses.

Roger Harris encapsulates this dilemma: “If a client comes in who is eligible for the Employee Retention Credit but has not applied for it yet, you’re between a rock and a hard place. Technically, the law still allows them to apply, but there’s a law floating around that could make it retroactive.” This highlights the importance of staying informed about the latest developments and adapting quickly to new circumstances.

Preparing for the Future: Navigating Tax Law Changes and Expirations

Looking ahead, businesses must also prepare for the potential expiration of Tax Cuts and Jobs Act (TCJA) provisions and the influence of political factors on tax policy. Roger Harris notes, “Election day is the first Tuesday in November. You may hear people talk about potential tax law changes, but I don’t expect anything to happen until after that election. We’ll get a sense of who’s calling the shots, but it’s going to be a major change.”

This uncertain landscape underscores the need for businesses to stay informed, consider the impact of potential changes on their financial planning, and cultivate a proactive and adaptive mindset.

Key Takeaways for Tax Practitioners and Their Clients

The hosts offered this advice to tax pros and their clients:

Stay informed about the latest developments in worker classification rules, COVID-19 relief measures, and potential tax law changes.
Seek guidance and understand the nuances of these developments to avoid penalties and ensure compliance.
Cultivate a proactive and adaptive mindset to navigate the ever-changing tax landscape effectively.
Stay attuned to the political climate and its influence on tax policy for effective long-term planning and strategic decision-making.

The Path Forward: Thriving in a World of Constant Change

As the tax landscape continues to evolve, tax practitioners and their clients must embrace a mindset of continuous learning and adaptation. By staying informed, seeking guidance, and remaining proactive, businesses can confidently navigate the current environment’s complexities.

The insights shared in this episode of Federal Tax Updates serve as a valuable compass for those navigating the ever-changing tax landscape. Listen to the full episode to dive deeper into these critical topics and gain more valuable insights.