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.