FACTUAL ISSUES IN 1031 EXCHANGES
Here are some key principles that underlie the specific advice I provide to clients who are thinking of pursuing a tax-deferred exchange of real estate under Section 1031 of the Internal Revenue Code. These general principles may apply to specific facts and circumstances in unique ways, so please reach out for an individual consultation if you would like to explore your options with me. The business benefits of 1031 exchanges, in terms of postponing gain, should be weighed against the transactional costs of documenting an exchange and the possibility of an income tax audit.
- Section 1031 Has Been Revised Often. Most recently, significant statutory changes took place in 1984, 1989, and 2017.
- Section 1031 Nonrecognition Exchanges. Section 1031 provides for gain deferral only on certain property held for investment or for productive use in a trade or for business, but not inventory held primarily for sale.
- Basis of Property Acquired in 1031 Exchange. The Replacement Property will have an adjusted basis dependent in part on the basis of the Relinquished Property. This means that the holding period of the Replacement Property will “tack” onto the holding period of the Relinquished Property.
- Time Limits on Non-Simultaneous Exchanges. The 1979 decision in Starker caused Congress to impose statutory times for designating and acquiring Replacement Property in an exchange.
- Extracting Equity Before or After the Exchange. New mortgage debt placed on the Relinquished Property before an exchange, or against the Replacement Property after the exchange, was considered In several Tax Court cases and Private Letter Rulings issued in between 1983 and 1994. Currently, it is said that debt may be placed on the Replacement Property a “nanosecond” after the exchange. New debt secured by a Relinquished Property in anticipation of an exchange could still be considered by the IRS to be taxable under a step transaction analysis.
- The “Reverse” Exchange is Authorized. Under Revenue Procedure 2000-37, the Replacement Property is acquired before the Relinquished Property is conveyed. Specific timelines are required to meet the Revenue Procedure.
- Exchanges Involving Undivided Fractional Interests. Ownership of a Relinquished Property by tenants-in-common can sometimes facilitate exchanges for different Replacement Properties by the owners, or exchanges by some, and taxable sales by others. Revenue Ruling 75-374, for instance, concluded that the ownership of an apartment building was by co-owners who were not partners. Revenue Procedure 2002-22 set forth 15 conditions for the IRS to consider ruling that tenants-in-common are not partners.
- Exchanges Are Now Limited to Real Property. In 2017, Section 1031 exchanges became limited to transactions involving real property.
- 2020 Regulations. To implement the 2017 changes to Section 1031, the Treasury Department issued Regulations in 2020. The Regulations defined real property as: (1) land; and (2) an inherently permanent structure.
- Examples Given in the Regulations. The Regulations give examples of items that are or are not to be classified as real property.
- Incidental Personal Property. Under the 2020 Regulations, incidental personal property may be identified as part of a like-kind exchange. However, the personal property will be considered not to be of like-kind with the real property. The personal property must therefore be recognized in connection with the transaction.
- Factual Determinations Remain Critical. In a dispute concerning Section 1031, there will typically be factual issues critical to the taxpayer and to the IRS.
- No Recent 1031 Authority for Certain Issues. There have been no recent federal tax developments concerning: (1) drop and swap exchanges; (2) swap and drop exchanges; or (3) exchanges by tenant-in-common owners.
More In-Depth Study Is Available. This Newsletter is also available as a more detailed In-Depth Study. If you, or someone you are in contact with, have an interest, please contact us. If you have questions about any real estate or federal income tax topics, we can schedule a call to discuss your concerns.
No Legal Duty Is Created. This Newsletter is for general information only and does not create any relationship between the William R. Sylvester Law Firm, LLC, or William R. Sylvester, and any other person or entity. A legal relationship will arise only on the mutual execution of a written retainer agreement.
WINTER 2023