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If you have a client who is planning to sell, purchase, or construct real property, you should explore the possibility of structuring the transaction as a like kind exchange under Section 1031 of the Internal Revenue Code. Section 1031 allows taxpayers to exchange business or investment property ("relinquished property") solely for other business or investment property ("replacement property") without recognizing gain or loss. The gain or loss in the relinquished property is preserved in the replacement property through exchange basis provisions, which give the taxpayer a basis in the replacement property equal to his basis in the relinquished property, with certain adjustments. These rules work together to allow the taxpayer to defer federal income tax on the exchange until the replacement property is disposed of in a taxable transaction.
Although Section 1031 applies to exchanges of personal property, it is most often used in real estate transactions. Real estate developers and investors can postpone gain recognition indefinitely by engaging in like kind exchanges when they want to cash out of a property and reinvest the proceeds in other real estate. This allows real estate investors to diversify their portfolio by trading one class of real estate for another. Like kind exchanges also have the estate planning benefit of allowing family members of a decedent to exchange a single parcel of property for several smaller parcels so that each beneficiary can elect whether to retain or sell the property received from the estate. If a decedent holds property received in a like kind exchange at death, his or her beneficiaries will take a fair market value basis in the property under current law, providing a complete exemption from tax on the gain that accumulated during the decedent's life.
For Section 1031 to apply, the property received in the exchange must be of "like kind" with the property given up in the exchange. Properties will be of like kind with each other if they are of the same nature or character, even if they differ in grade or quality. This standard is applied broadly to real estate, which is like kind with other real estate regardless of whether each property is improved or unimproved. Personal property of the same asset class is considered like kind with property within the same asset class. However, properties used primarily within the United States are not like-kind with property used abroad. Exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets are excluded from Section 1031.
If, in addition to property of like kind, the taxpayer also receives property that is not like kind (called "boot"), gain will be recognized to the extent of the boot, but loss will not be recognized. Any net debt relief resulting from the exchange is considered boot. Thus, full deferral of capital gain taxes will generally occur only if the taxpayer does not receive cash (i.e., if value of the acquired property is greater than or equal to the value of the relinquished property) and the mortgage on the acquired property is greater than or equal to the mortgage on the relinquished property.
Section 1031 only applies to property that is held by a taxpayer for productive use in a trade or business or for investment. However, the property exchanged and the property received need not be in the same category. A taxpayer may exchange business use property for investment use property, and vice versa. Whether the property is intended to be held for trade, business, or investment is determined based on facts and circumstances at the time of the exchange. Thus, if the taxpayer can prove that the property was acquired with the intent to hold the property for trade, business, or investment use, the property can later be changed to personal use property if the taxpayer changes his mind. What is trade, business, or investment use property today may become personal use property in the future. Although there is no formal holding period requirement, the IRS has been successful in challenging transactions where the property was converted to personal use shortly after the exchange.
Most clients will find it difficult to find a seller who is willing to accept the client's property in exchange for the seller's in a simultaneous swap. Multiparty exchanges can be structured to allow these clients to qualify for nonrecognition under Section 1031. For a multiparty exchange to qualify, three requirements must generally be satisfied. First, the transactions that occur during the exchange period must be mutually dependent parts of an integrated plan designed to result in an exchange of property. Second, the transactions must result in the exchange of property without the transferor's receipt of, or control over, cash or non-like-kind property. This is usually avoided by the qualified intermediary safe harbor discussed below. Finally, the transferor must retain rights in the property until the exchange takes place.
If certain conditions are met, Section 1031 and the related regulations allow a lapse between the sale of the client's property ("relinquished property") and the acquisition of the new property ("replacement property"). In a typical (forward) deferred exchange, the client has 45 days from settlement on the relinquished property to identify the replacement property. The client can identify up to three properties at fair market value, or more properties providing that the total fair market value does not exceed twice the value of the relinquished property. Closing on the replacement property must occur within 180 days of closing on the relinquished property.
As mentioned above, the actual or constructive receipt of money or non-like-kind property in the full consideration for the relinquished property will preclude like-kind exchange treatment. This presents a difficulty for deferred exchanges, where there is a lapse in time between the sale of the relinquished property and acquisition of the replacement property. The Section 1031 regulations provide a set of safe harbors designed to protect against actual or constructive receipt of sale proceeds. The most commonly used safe harbor involves a qualified intermediary - an independent party who facilitates the exchange by selling the relinquished property and acquiring the replacement property for the taxpayer. The regulations also provide that constructive receipt will not occur because of security arrangements, such as guarantees, security interests, or letters of credit, or because the money is held in a qualified escrow account while the taxpayer searches for and acquires replacement property.
Some clients may find a property they want to acquire before deciding which property they want to give up or finding a buyer. Revenue Procedure 2000-37 allows these taxpayers to engage in a reverse deferred exchange, where replacement property is purchased before the relinquished property is identified. Like the constructive receipt prohibition in a forward exchange, the taxpayer cannot take title to the replacement property while still holding the relinquished property. To avoid this, the Revenue Procedure allows the taxpayer to "park" the replacement property with an exchange accommodation titleholder (EAT) until a relinquished property is identified. The EAT may, but need not be, a qualified intermediary. The EAT will generally be treated as the owner of the property during the parking period if it holds either legal or beneficial title to the property pursuant to a written Qualified Exchange Accommodation Arrangement (QEAA). The EAT and the taxpayer must enter into the QEAA within five days and close within 180 days of the EAT's acquisition of legal or beneficial ownership in the replacement property. Certain commercially reasonable arrangements are permitted: the taxpayer may guarantee debt incurred by the EAT to improve the property, advance funds to the EAT to pay the purchase price, lease property from the EAT, supervise the property or construction, and protect the EAT against risk from fluctuations in value.
Congress put backstops in place to prevent gamesmanship between related parties. If a taxpayer exchanges property with a related person and either of them dispose of either property within two years, the taxpayer is required to recognize the amount of deferred gain in income in the year in which the disqualifying disposition occurs. Although Section 1031 would no longer prevent loss recognition in these circumstances, Section 267 will prevent the taxpayer from recognizing loss on the exchange. Loss that is disallowed for one party will generally be transferred to the other party, who may use it to offset gain on a subsequent disposition of the property received.
In the atypical case that the taxpayer wants to recognize gain or loss on the exchange of properties (such as to obtain a high basis or increase losses), the parties may intentionally structure the exchange to fail the like kind exchange requirements. Under Revenue Ruling 69-119, the step transaction doctrine will apply to make Section 1031 applicable if the steps used to cause recognition are mutually dependent. If a taxpayer "sells" qualifying property to a buyer then "purchases" qualifying property from the same person pursuant to a prearranged plan, the IRS can recast the transaction as a like kind exchange. Only the IRS can recast the transaction - the taxpayer is generally bound to the chosen form. If the client has legitimate non-tax reasons for the structure of the transaction, the step transaction doctrine will generally not apply solely because the relinquished property ends up in the hands of the former owner of the replacement property.
Before recommending a Section 1031 exchange to a client, it is important to have a clear understanding of the tax characteristics of the relinquished and replacement properties in order to determine the potential benefits of a like kind exchange. The client's present and future tax rates and long-term goals with respect to the properties is also an important consideration. If a Section 1031 exchange is advisable, a thorough understanding on these rules will help to ensure like kind exchange treatment.
About the Author
Jeramie J. Fortenberry is an associate with the Gulfport, Mississippi, office of Balch & Bingham LLP.