Section 1031 Exchange

Like-Kind Exchanges Under Code Section 1031

Under Section 1031, a taxpayer can exchange an investment or business property for another investment or business property (like-kind) and defer the recognition of capital gains. Like-kind properties are defined as properties of the same type. In the case of Section 1031, they are properties used for investment or business purposes. It also allows a taxpayer to sell an investment or business property and to use the proceeds of that sale to purchase its replacement.

A client who wishes to take advantage of Section 1031 should seek advice as to:

  1. Whether the properties meet the qualified use test.
  2. Whether the properties exchanged are like-kind.
  3. If the property is sold to purchase another, how the proceeds are being handled between the time of the sale and the time of the purchase.
  4. How much the taxpayer must spend on replacement property to achieve a fully deferred exchange.
  5. Locating and contracting with a qualified intermediary.

Why Exchange?

Section 1031 allows a taxpayer to exchange (or sell) investment or business property for another without the recognition of realized gain. A taxpayer may want to consider a Section 1031 exchange for the following reasons:

  1. If an exchange of investment or business property qualifies for Section 1031, the taxpayer may defer the recognition of capital gains.
  2. Allows the taxpayer to use all the proceeds from the sale of the investment or business property to purchase its replacement without reduction for taxes.
  3. Allows the acquisition of different types of properties as long are they are used for investment or business purposes, which helps diversify real estate portfolios without tax consequences.
  4. May shelter income from the alternative minimum tax using the Section 1031 exchange.

Types of Exchanges

1. Direct Exchange

  • A direct exchange is one in which two taxpayers exchange property directly with each other.
  • Since it is unusual for two owners with property to exchange to locate each other, a direct exchange typically occurs between related parties, which will be discussed later on below.

2. Deferred Four-Party Exchange

  • In a deferred four-party exchange, the taxpayer enters in an exchange agreement with an intermediary.
  • The taxpayer agrees that proceeds from the sale of the relinquished property will be transferred to the intermediary, which will then be used to acquire the replacement property.
  • The taxpayer must identify the replacement property within 45 days of the sale, and it then needs to be acquired within 180 days.

3. Buyer-Accommodator Exchange

  • An exchange in which the buyer of the relinquished property is contracted to acquire replacement property with the exchange funds for the taxpayer.
  • In the Starker Case, because the taxpayer and buyer entered into an exchange agreement calling for the buyer to acquire replacement property with the purchase funds, the sale of the relinquished property by the taxpayer and the acquisition of the replacement property were integrated transactions.
  • Because Starker had conveyed the relinquished property to the buyer but had not been paid, the buyer was required to pay a “growth factor.” The court held that this growth factor is interest and should be treated and taxed as such.

4. Reverse Exchange

  • In a reverse exchange, the taxpayer arranges to have the replacement property acquired by an intermediary, and then acquires it from the intermediary once the relinquished property is sold.

5. Build-to-Suit Exchanges

  • The taxpayer exchanges business property for land upon which it wants to construct a building for business use.

6. Related Party Exchanges

  • In a related party exchange, both parties must hold their exchanged properties for two years, or the exchange will be disallowed.

Essential Elements of a Section 1031 Exchange

Several key elements must exist for a 1031 exchange to occur. In order for an exchange to qualify under Code Section 1031, both properties in the exchange must pass the qualified use test and be like-kind. The identity of the exchanging party is also very important in determining the qualification for a 1031 exchange. These elements are briefly discussed below.

1. The Qualified Use Test

The qualified use test determines if the properties being exchanged are held for investment or business use. Properties held for investment must have the potential to produce income or be held for their increase in value.

Taxpayers often believe properties other than their own personal residences qualify for a 1031 exchange. However, this is incorrect. Many properties cannot qualify as investment properties even though they are not residential.

2. The Like-Kind Test

To qualify for a 1031 exchange, both properties must be like-kind. Like-kind is defined as any properties that are considered to be of the same type. It is broadly interpreted in Code Sec. 1031. The properties are considered like-kind if they pass the qualified use test, which ensures that both properties are held for investment or business use.

3. Identity of Exchanging Party

Although it is not mentioned in the Code, the taxpayer selling the relinquished property must be the same taxpayer acquiring the replacement property. This principle was pronounced in the Starker case. Two of the properties acquired by Starker with exchange proceeds were transferred directly to his daughter rather to him. The court ruled that “continuity of title” is required to receive non recognition treatment.

Basic Structure of a Deferred Exchange

A successful deferred exchange requires the following procedures and documentation:

  1. The taxpayer must enter into an exchange agreement with a qualified intermediary before closing of the sale of the relinquished property. The agreement requires the intermediary to hold the exchange proceeds and then use the proceeds to acquire replacement property for the taxpayer. The agreement also must prohibit the taxpayer from obtaining the funds before replacement property is received, if the taxpayer fails to identify replacement property within 45 days of closing, or the taxpayer fails to acquire replacement property within 180 days of closing.
  2. The net proceeds of the sale are transferred directly to the intermediary, which holds the funds until needed for closing of the replacement property. The taxpayer may earn interest on the funds, but it cannot be paid to the taxpayer until after receipt of replacement property. The interest is taxed as interest income.
  3. The taxpayer must identify replacement property within 45 days following sale of the relinquished property. Identification must be in writing and is typically given to the intermediary.
  4. The taxpayer must acquire the replacement property within 180 days following closing of the relinquished property or the date when the taxpayer’s nest tax return is due, whichever occurs first.

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