Opinion on validity of 1031 Exchange

[Michael Acosta]

Hi,

I hoping one of our accounting gurus that like to get in the weeds might offer their opinion on this case.

I did a land for land 1031 exchange with a company in 2022/2023. The original property was purchased on 9/7/2021, it was subsequently sold 7/8/2022 for an 80% profit. The replacement property was purchased on 4/5/2023. I was able to extent the 180 days due to disaster relief. The intent at the time of purchase of both properties was to construct a single family home that would become a short term rental serving the smoky mountains leisure market in North Carolina. The replacement property was purchased because it had a better view than the original property. In 2025 I was successful in constructing a home and planned to subsequently place the home into a short term rental business. However, shortly after the home was completed it was discovered that the well providing water to the home was producing almost no water. This was a surprise because we were provided a well yield certificate by the well driller that had been recorded with the county. We subsequently had the pump pulled and well yield retested, to find out the well was producing only 2 gallons per hour. For reference, an average person uses 80 gallons per day, and the home is a 4 bedroom home designed to accommodate 8 people. Since discovering the water problem we have undertaken a large effort to remedy the problem. We considered fracking the well, but it had already been fracked and a specialist advised us that they thought an additional attempt would be unsuccessful. We have looked into drilling a new well, but the cost would be very high because there are no easy places to do a new well on our property due to terrain, easements, and setbacks. The estimates I'm getting are over $40K. An option that we did decide to go with is a whole house rainwater capture system. We had that installed in the hopes that it would provide enough water to support a rental, but after living with the system for the last 5 months, we are very confident that the home would run out of water on a consistent basis as a full time STR. The supply of rainwater has been too inconsistent and low in volume to reasonably believe it would be adequate. That system cost $36K. After purchasing the land, constructing the home, and incurring unexpected post construction expenses, we do not currently have the funds to drill a new well and run the water supply to the home. So, we would like to abandon the idea of renting it out and just convert it to a second home that will only have occasional use. The reason I'm reaching out is to get an opinion on whether the 1031 exchange is still valid due to the fact that I have a preponderance of evidence that I always intended to rent the home, and only through factors out of my control did the property become unsuitable to be put into such a business. Or whether I should amend my tax return, withdrawing the exchange and paying the taxes and interest due. I'm not sure if someone has knowledge of case law when it comes to intention at the time of the exchange.

Some of the evidence I have that that support my intention to make the property a rental.

-I named the property for marketing.(ie Green Mountain Cabin)

-I opened an LCC in the home’s name.

-I opened a business account and credit card and began running all expenses through the business account tied to the LLC

-I began marketing the property on social media, giving updates on the construction progress and when the home would be available for rent in the future. Also, marketed things to do in the area to draw people to the home.

-I had branded merchandise made including a sign at the driveway.

-I kept detailed logs of my material participation going back 2 years.

-I kept a detailed expense log and kept all receipts for expenditures.

-I engaged routinely on the phone, in person, and through email with the local property management company that I planned to hire. They provided me information about how to outfit the home for rental.  I did not sign the management agreement, as I was waiting for the water problem to resolve. Which it didn’t. 

I have Clear, detailed emails explicitly explaining my intention to place the property into a rental business with:

-Buyers Agent from the acquisition of first property(Who was also a local rental property manager who I intended to hire to rent the home)

-Buyers/Sellers Agent for the replacement property

-Local rental property manager who provided me with detailed income statement for comparable rentals in my area.

-Insurance agent(who provided me quotes on STR insurance)

-Loan officer who provided the loan. I inquired to ensure the mortgage rates I would be quoted were for STR use. I also inquired about moving the home into an LLC

-Developer/Owner who sold me the replacement property. I needed him to approve my house plan and explained that the style I planned to build was necessary because it was popular with renters in the area.

-Builder

I have documented emails and texts with each of these parties discussing my intention to put the property into a rental business.

With regard to the water failure. I have texts and emails discussing the problem at length. I’ve received quotes for fracking, new well drilling, and rainwater systems. All from different companies. I have documented discussions with the builder about the water problems.

There is not a chance that in an audit, that the IRS would not agree with me that my genuine intention was to make the home a short term rental, from the start. However, I’m just not sure whether they will want to have seen me put it on the market and documented its unsuitability by way of consistent water failures and subsequent removal from the rental market. I’ve tested having 8 people staying in the home for a week. It failed. We ran out of water. If I were a renter paying $600/night, and I couldn’t flush the toilet, I would be pissed. As the owner, I do not want to be put in that situation. 

Do you have an opinion on whether I should withdraw the exchange or have I done enough through “intent” to have a valid, defensible exchange. Many articles online claim that intent is the primary thing the IRS would look for in an audit.

Thank you for anyone who’s willing to share an opinion on the matter. And yes, I’ve contacted a CPA and have gotten different answers, more or less saying it’s up to you.

[Johnny Lujan]

Hello!

I would not jump straight to amending solely because the property may now become a second home. The key issue is not just what the property became later; it is what the relinquished and replacement properties were held for at the relevant times.

Based on what you laid out, you seem to have a lot of favorable facts showing investment/rental intent: STR planning, business accounts, LLC setup, marketing, property management discussions, STR insurance quotes, rental projections, construction communications, and then a documented water issue that appears to have changed the facts after the exchange.

That said, I would be careful with the statement that the IRS would definitely agree. The weak points I’d want addressed are:

1. The relinquished property was only held for about 10 months before sale.
2. The replacement property apparently was never actually placed in service as a rental.
3. If it is converted to personal/second-home use before any bona fide rental activity, that creates audit risk.
4. The vacation-home safe harbor may not help if the property was never rented.
5. Subsequent personal use can be used as evidence against original intent, even if it is not automatically fatal.

To me, the best argument is not "intent alone fixes everything." The better argument is: "The property was acquired and developed for STR/investment use, and only after substantial documented unforeseen water issues did the property become unsuitable for that intended business use."

I would not manufacture rental activity or put guests in a house that cannot safely/reliably support them. But I would preserve a very clean file: timeline, 1031 documents, acquisition documents, construction records, STR marketing, property manager communications, insurance quotes, rental projections, water test results, well reports, rainwater system documents, contractor quotes, and notes explaining when and why the decision changed.

This is probably worth paying a CPA or tax attorney to write a formal position memo. I would not amend without that deeper review. From the facts you provided, I would view this as potentially defensible, but not risk-free.