Anyone who is still around from the Warren Harding administration is entitled to some respect. And maybe even a bit of … fear?
The tax law’s “like-kind exchange” provision—popularly known as “Section 1031 exchanges” after its current home in the Internal Revenue Code—may indeed be ancient, but it remains spry enough to be a great tax planning tool. But it is also still sly enough to lure taxpayers to grief. Let’s review some hard-learned taxpayer lessons to help us all stay on Section 1031’s good side.
A like-kind exchange allows a taxpayer to not recognize taxable gain on a disposition of business or investment real property if other real property is acquired in the exchange. (Personal property is no longer eligible for Section 1031 deferral.) While these are called “tax-free” exchanges, the tax is technically deferred and will be payable on a later taxable sale of the replacement property acquired in the swap.
The rules are flexible. With proper paperwork and planning, a property can effectively be sold for cash, and the cash can be used to acquire replacement property, while still qualifying for Section 1031 deferral. But formalities must be observed. Transactions that look much the same can have very different tax results if a taxpayer makes a technical mistake.
Don’t touch the cash!
A California couple owned rental property. They sold it. They then bought other properties and reported the transaction as a Section 1031 deal. The IRS disagreed. The Tax Court explains:
An essential prerequisite for nonrecognition treatment under section 1031 is that there be an “exchange” of properties. A sale of one property for cash followed by a separate investment of the proceeds in “like-kind” property simply does not qualify as an exchange.
Fortunately, the tax law now allows transactions like this to work—but only if the proceeds of a sale are deposited with a “qualified intermediary, a middleman meeting specific tax law conditions.”
Once a subject property is sold, the seller of the property has 45 days to identify replacement properties and 180 days to close. If the deadlines and other technical requirements are met, the gain on the proceeds held by the intermediary and used to buy replacement property is treated as deferred in a qualifying like-kind exchange. Failure to meet the conditions results in a taxable sale.
Beware relatives (and related businesses).
Sometimes, a taxpayer does everything right, with proceeds paid to a qualified intermediary, but then it turns out that 180 days isn’t enough to close on replacement property. The taxpayer needs to close on something in a hurry. With time running out, the taxpayer, knowing that a relative or a controlled business has a great replacement property, instructs the intermediary to buy the property from the related party to meet the 180-day purchase timeline.
A Hawaiian real estate company tried this gambit, claiming Section 1031 deferral on $12 million in gains. The third-party purchaser deposited the purchase price with a qualified intermediary. The taxpayer had the third-party purchaser of its property deposit the purchase price with a qualified intermediary. At the taxpayer’s direction, the intermediary used the proceeds to purchase replacement property from a related corporation.
The IRS threw a penalty flag. The Tax Court upheld the call on the field, pointing to a provision in Section 1031 limiting transactions with related parties. If a related party acquires a property from a taxpayer, there is no like-kind exchange if the related party sells the gain property within two years. The tax law treats the related corporation as having in effect sold the original property immediately to the third-party purchaser, wrecking the tax results by triggering the gain.
Related party exchanges are possible, but they need to be true exchanges. If a property ends up with a third party within two years, the original tax deferral is lost.
Be sure you are buying real estate, not a real estate partnership.
Sometimes, taxpayers looking to sell a property want Section 1031 deferral, but they don’t want to manage real estate. “Tenancy in common” deals may be attractive to these people. Done properly, the taxpayer gets like-kind exchange treatment, while somebody else gets the headaches of day-to-day management of the replacement property.
This was the idea behind a deal when a couple had a $10 million gain on an investment condominium unit in New York City. Their intermediary used the proceeds to acquire an interest in an apartment building. The couple reported the transaction as a qualifying like-kind exchange. Everything went well until tax time, when they got a partnership K-1 from the apartment building partnership—meaning they had acquired a partnership interest, NOT a tenancy in common.
Remember, a transaction has to involve “like-kind” property to qualify for Section 1031 deferral. One of the rules of Section 1031 is that partnership interests and corporation stock never qualify as “like-kind” property. By acquiring their interest in the apartment building as a partnership interest, rather than a tenancy in common, they forfeited their ability to use Section 1031.
Section 1031 is great, but be careful.
Like-kind exchanges remain one of the most useful items in the tax planning toolbox after 98 years. Tools used properly can build great things. Powerful tools used carelessly are dangerous. Stay safe, and bring in your tax advisor when you want to use Section 1031.
| Joe Kristan