Section 1031 Exchanges: Underused Tax- Planning Tool

By Stephen A. Wayner

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JUNE 2005 - IRC section 1031 provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

Nonrecognition of gain or loss does not apply to exchanges of the following:

  • Stock in trade or other property held primarily for sale;
  • Stocks, bond, or notes;
  • Other securities or evidences of indebtedness or interest;
  • Interests in a partnership;
  • Certificates of trust or beneficial interest; or
  • Choses in action.

Stock in trade or property held primarily for sale. Property that normally would be described as the inventory of a dealer of goods is a stock in trade. Stock in trade is property held for sale to customers in the ordinary course of business. Even real estate (which is normally described as like-kind and not stock in trade) can be considered stock in trade or dealer property when the taxpayer sells individual lots as part of its business [Margolis v. Comm’r, 337 F2d 1001 (9th Cir. 1964)].

Distinguishing between dealer property and property held for productive use in a trade or business or for investment can be difficult, and there are no safe harbor provisions to rely on. The IRS reviews certain factors to determine whether the property is being held for sale to customers in the ordinary course of business:

  • The taxpayer’s ordinary business;
  • Listing the property for sale with brokers;
  • The number, frequency, and continuity of sales by the taxpayer;
  • The purpose for holding the property when acquired;
  • The purpose for holding the property that was replenished;
  • The extent and nature of the transactions involved;
  • The extent of the improvements, if any, made to the property;
  • The purpose for which the property was being held when sold; and
  • The amount of advertising or other efforts that were used in trying to obtain purchasers for the sale of the property [Klarkowski v. Comm’r, T.C. Memo 1965-328, 1965 WL 1278 (T.C. 1965)].

The taxpayer must structure purchases or sales carefully because the IRS may classify transactions as dealer transactions if the taxpayer enters into a joint venture with a dealer or if the taxpayer agrees in its purchase and sale contract to help the dealer or purchaser subdivide the property prior to closing.

A dealer may, however, hold assets for resale in the normal course of business and segregate its nondealer property that the taxpayer is holding for investment purposes.

Other property held primarily for sale. If the property is not stock in a trade or business or for sale, it still may not qualify for nonrecognition treatment under IRC section 1031. The IRS will look at a number of factors, such as the purpose for which the replacement property is to be held, the use of the property during its holding period, and the intent of the taxpayer at the time of exchange [Brauer v. Comm’r, 74 TC 1134, 1980 WL 4427 (1980)]. If the taxpayer has a contract to resell the replacement property prior to the exchange for the replacement property, then the taxpayer’s intent was not for investment or trade or business purposes [Griffin v. Comm’r, 49 T.C. 253, 1967 WL 1261 (T.C. 1967)].

Stock, bonds, or notes. Stocks, bonds, or mortgage notes do not have the right to nonrecognition status under IRC section 1031. Stock, however, can be exchanged under corporate reorganizations, and
U.S. Treasury Bonds can be exchanged but not under section 1031.

Other securities or evidence of indebtedness or interest. The IRS has taken the position that any securities or evidences of indebtedness or interest are excluded from nonrecognition under IRC section 1031. Therefore, mortgages, notes, and equity interests in financial enterprises other than direct ownership of the underlying property do not qualify for nonrecognition treatment (Revenue Ruling 78-135, 1978-1 CB 256). Nevertheless, the federal government defines a security differently under section 1031 than it does under the Securities Act of 1933 regulations. Consequently, tenancy in common (TIC) interests do qualify as a real estate interest for section 1031 exchanges even though they are defined as a security under section 9.09 of the Securities Act of 1933.

Real estate investment trust (REIT) interests. An interest in a REIT is defined as a security and therefore will not qualify as a replacement property for a section 1031 exchange (Letter Ruling 8206109). An alternative solution, the tax-free contribution of real estate for a Up REIT or a Down REIT under IRC section 721, is beyond the scope of this article.

Partnership or limited liability company interests. IRC section 1031(a)(l) states that nonrecognition treatment will not apply to any exchange partnership interests, whether the interests exchanged are general or limited partnership interests; this holds whether the interests are in the same or different partnerships. However, a limited partnership interest can be exchanged for a general partnership interest, and vice versa, if in the same partnership under IRC section 721. A limited liability company (LLC) is now allowed nonrecognition treatment if it is taxed as a partnership and not as a sole proprietorship. When a partner purchases the remaining interest of the other partners in the partnership, those purchases may qualify as a replacement property in an exchange by the purchasing partner (Revenue Ruling 99-6, 1999-1 CB 432). If the partnership had elected under IRC section 761 to be excluded from subchapter K treatment, the interest owned by each individual partner is treated as an asset, the exchange of which would qualify in a section 1031 tax-deferred exchange.

Certificates of trust or beneficial interests in trusts. Certificates of trust and beneficial interests do not qualify for nonrecognition, because they represent interests in the stock of a corporation or trust. Interests in land trusts, however, are considered interests in real property and not interests in personal property or beneficial interests in the trust. The historical reason is that the beneficiary (taxpayer) retains the exclusive control, operation, and renting or selling of the property, as well as the responsibility for paying all taxes and filing the necessary tax returns, as stated in the land trust agreement (Revenue Ruling 92-105).

Choses in action. A chose in action is a right to recover money or other personal property by a judicial proceeding. IRC section 1031(a)(2) excludes an exchange of a chose in action from like-kind exchange treatment.

Advantages and Hidden Secrets

The realized gain in an IRC section 1031 exchange is deferred until the property acquired in the exchange is disposed of in a subsequent taxable transaction. This gain may be avoided altogether if the replacement property is held by the taxpayer at time of death.

The primary benefit of a section 1031 exchange is the ability to use the entire equity to acquire a replacement property. Therefore, a taxpayer who has held on to property long enough for it to appreciate in value has the opportunity of exchanging it for a more lucrative or preferable property. The exchange transaction may be totally or partially tax free.

Leveraging appreciation. Most taxpayers invest in real estate because they have the opportunity to leverage their investment and obtain appreciation using a lender or a seller to finance part of the purchase price. In a section 1031 exchange, the taxpayer can also leverage the new replacement purchase on the taxes saved by exchanging.

Example. Tim Taxpayer decides to sell a duplex that he has owned for investment for 10 years; he originally purchased it for $70,000 and it is now worth $750,000. His real estate broker recommends engaging a qualified intermediary in a tax-deferred exchange, thereby deferring payment of capital gains taxes. The real estate broker finds Tim an office building valued at $3 million for his replacement property. Tim is successful in the exchange process and consequently does not pay capital gains taxes. (Capital gains tax at 15% on the $680,000 profit results in $102,000.) He is able to purchase the office building, leveraging the net proceeds from his duplex. Tim was able to purchase a property worth $408,000 more by using the section 1031 exchange process:

 
Sale
Exchange
Net equity
$ 750,000
$ 750,000
Capital gains tax
102,000
-0-
Equity to acquisition *
648,000
750,000
Proposed acquisition*
$2,592,000
$3,000,000
*Presuming a 25% down payment

Increased cash flow. Many taxpayers own either raw land or property with a low cash-flow return, such as farmland, raw acreage, or income-producing property that generates little or no cash flow compared to the property’s fair market value. The section 1031 exchange process allows the taxpayer to convert an existing low- or no-cash-flow property into a property that produces a more desirable cash flow while using the profit on the relinquished property tax free.

Relocation. In a section 1031 exchange, the taxpayer can relocate the property presently owned by exchanging it for property in another location. A taxpayer may want to take advantage of having the replenished property in a different location because, for example, she is moving and wants her investment nearby for management purposes. Or, the taxpayer may want to relocate to a different property due to that state’s income tax rates.

Consolidation and diversification. Taxpayers that own a number of properties may want to replace their various properties with a single property of equal or greater value. Conversely, the taxpayer may decide she wants to diversify from a single property into two or more smaller investment properties. Most taxpayers consolidate or diversify with the intent of having a greater opportunity for appreciation.

Nondepreciable property into depreciable property. Taxpayers can obtain the tax benefit of depreciation when they exchange from a nondepreciable asset, such as raw acreage, into a depreciable asset, such as an apartment building.

Disadvantages

Transactional costs. In some cases, the transactional costs may be greater than the typical sales transaction. Some costs may be higher, or, in addition to typical closing costs, include settlement fees, intermediary fees, or tax and attorney preparation fees and costs. If the gains are small, these costs may outweigh the benefits of an IRC section 1031 exchange.

Limitation on use of equity. The taxpayer does not have the use of the net sales proceeds when undertaking a section 1031 exchange, because the qualified intermediary is holding the funds for the purpose of reinvesting them into the replacement property. If the taxpayer takes cash out of the transaction, the cash received is subject to the appropriate tax.

Reduced basis of replacement property. In a section 1031 exchange, the taxpayer receives a carryover tax basis in the replacement property. The replacement property’s basis equals the cost of such replacement property less the amount of gain that was not recognized in the exchange. Therefore, the taxpayer acquiring the replacement property will have a lower cost-recovery deduction each year than if the taxpayer had purchased the replacement property. A straightforward purchase, however, will not allow the taxpayer to defer paying taxes.


Stephen A. Wayner, Esq., CES, is vice-president of Bayview Financial Exchange Services, LLC, a qualified intermediary based in Miami, Fla.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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