In Adams v. Commissioner (Tax Court, January 10, 2013), the taxpayer owned a home in San Francisco that he occupied as his principal residence. In 1979, the taxpayer moved out of the home and rented it to a tenant. In 2003, the tenant moved out and the taxpayer sold the home through an exchange intermediary, hoping to purchase qualified replacement property and complete a Section 1031 exchange. The taxpayer had a son living in Eureka, California, and he bought a home there as the replacement property for his exchange. He rented the home to his son at a belowmarket rent because his son possessed building expertise and made significant improvements to the home while he was living there.
The IRS took the position that the Eureka home was not qualified replacement property for the exchange because the taxpayer bought it with the intention of letting his son live there at below-market rent. The Tax Court found in favor of the taxpayer, determining that the taxpayer did not intend for the rental to be at less than fair market value because the son agreed to make substantial improvements to the home. The opinion contains no discussion about whether the taxpayer should have reported the value of the improvements as additional rental income.
The lesson to take from this case is not the fact that the taxpayer prevailed but rather that he had to go to the Tax Court in order to prevail. The IRS did not like the fact that the replacement property was rented to a family member for a stated rent that was below current fair market value. This is not the optimal way in which to structure an exchange.