When investment property is sold, capital gains taxes generally apply to any realized gain. Section 1031 allows investors to defer recognition of that gain when property held for productive use in a trade or business, or for investment, is exchanged for like-kind replacement property.

That framework lets investors preserve capital for reinvestment, shift investments across regions, move from older properties into newer ones, and diversify a real estate portfolio. But it also raises a recurring question when residential property is involved: was the replacement property really acquired for investment, or was it effectively purchased as a personal residence?

The general rule for residential replacement property

The IRS requires like-kind replacement property, and it does not permit the taxpayer's personal residence to serve as exchange replacement property. At the same time, the holding purpose is determined by the facts and circumstances of the transaction, not by labels alone.

Practitioners often recommend that taxpayers hold a residential replacement property for at least two years before converting it to personal use and make meaningful efforts during that period to treat the property as an investment.

What happened in Reesink

In Reesink v. Commissioner, the taxpayers sold a tenancy-in-common interest in a San Francisco apartment building and shortly afterward acquired a single-family house and a vacant lot in Guerneville, California. Their mortgage application characterized the acquisition as an investment, and they took several steps to rent the property, including posting signs and distributing flyers.

Two prospective tenants looked at the property but declined because they could not afford the asking rent. The taxpayers did not reduce the rent and the property was never actually leased.

Why the court accepted investment intent

After carrying the Guerneville property for several months, the taxpayers decided to sell their San Francisco home because they could not afford all of their real estate costs. Only after the San Francisco sale closed, nearly eight months after acquiring Guerneville, did they move into the replacement property.

The court found it important that they had not stayed at the property or used it personally before moving in. It also gave weight to testimony that the taxpayers had originally planned to move there only after their son graduated from high school, which would have been more than two years after acquisition.

On that record, the court concluded that the taxpayers had principally acquired the property for investment and only later changed course because of financial pressure.

How Goolsby came out differently

The court contrasted Reesink with Goolsby v. Commissioner, where it found no bona fide investment intent. In Goolsby, the replacement purchase was contingent on the sale of the taxpayers' home, they sought advice about when they could move in, their rental efforts were minimal, they began improving the basement almost immediately, and they moved in within two months.

Those facts painted a very different picture from the more deliberate rental efforts and delayed personal use seen in Reesink.

Practical takeaway

Together, Reesink and Goolsby do not create a bright-line test, but they do clarify the burden taxpayers face when they convert residential replacement property to personal use before a two-year holding period has passed.

The lesson is that documents, rental efforts, acquisition timing, and personal-use history all matter. Taxpayers who want residential property to qualify as replacement property should build an investment record early rather than trying to explain intent after the fact.

Originally published in NYREJ, May 2012.