1031 Exchanges: Underused Tax- Planning Tool
Stephen A. Wayner
- 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
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.
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)].
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
The taxpayer’s ordinary business;
Listing the property for sale with brokers;
The number, frequency, and continuity of sales by the
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
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)].
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
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.
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)].
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
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
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
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.
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).
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.
and Hidden Secrets
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.
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.
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.
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:
to acquisition *
a 25% down payment
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
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.
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.
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.
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
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.
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.
A. Wayner, Esq., CES, is vice-president of Bayview
Financial Exchange Services, LLC, a qualified intermediary
based in Miami, Fla.