By Peter A. Karl, III
Deferred realty exchanges under IRC section 1031 can provide significant tax benefits for taxpayers. Deferred exchanges essentially allow a tax-free rollover reinvestment of the equity in a relinquished property. The author answers questions about section 1031, from the most basic, such as what real estate is eligible for like-kind treatment and what timelines apply, to the most complex, such as how to structure more sophististicated transactions and realty conversions. The author also discusses the role of the qualified intermediary and the implications for partnerships and closely held entities, as well as alternatives to section 1031 exchanges.
1. What is a deferred realty exchange?
Under IRC section 1031, a taxpayer is allowed to postpone the recognition of gain on the disposition of qualifying realty by the acquisition of replacement real property that will be later identified and purchased within a specific period of time. Structured properly, this deferred or nonsimultaneous exchange is essentially a subsequent tax-free rollover of the equity on the property being relinquished. By reinvesting the equity (as long as there is as much debt on the new property as the mortgage payoff on the disposed realty), capital gains tax and any IRC section 1250 unrecaptured gain taxable at the 25% rate can be completely avoided. This will occur even when there is a liability-over-basis problem (i.e., when the outstanding principal balance of the mortgage on the property exceeds the realty’s adjusted tax basis). In evaluating a deferred realty exchange, the existence of certain tax attributes such as any carryovers (NOL, capital loss, or passive activity losses) needs to be reviewed because their availability may preclude the necessity of using section 1031 for all or part of the transaction.
Tax deferral under IRC section 1031 does not include any recapture of tax credits (e.g., low-income housing or rehabilitation credits) that may be applicable if the property being exchanged has not been held for the requisite holding period (15 years for the low-income housing credit).
2. What qualifies as like-kind realty under IRC section 1031?
Qualifying property is broadly defined, for both the property being transferred and that received, as realty used for investment or business purposes.
Consequently, investment realty (held for either appreciation or rental) can be exchanged for real property used in a trade or business. Partial realty interests such as conservation easements and perpetual mineral or oil rights are exchangeable with other types of realty (including a land contract in which equitable title has been transferred), even a lease with at least 30 years remaining (including renewal options) can be exchanged for a fee-simple interest in realty.
If non-like-kind property is received (including any debt relief at the end of the exchange), there will be partial gain recognition; there is no all-or-nothing requirement of rolling over all of the equity and existing debt to the replacement realty.
In contrast, the standard for replacement property from an involuntary conversion under IRC section 1033 is a much narrower one: like-use. This means that if a restaurant is destroyed by fire, the insurance proceeds must be used to purchase or build another one. An involuntary conversion as a result of an eminent domain proceeding under IRC 1033(g), however, is an exception to this section’s like-use requirement and uses a like-kind standard similar to section 1031.
This postponement of tax can be continued with successive exchanges (stemming from the original property that was relinquished). This postponement will become a cancellation of the gain to the extent of the step-up in basis received by the heirs at death for property held in the decedent’s name.
3. Which real estate is not eligible for section 1031?
Personal use realty is not eligible. The personal usage may be considered nominal or substantial pursuant to the 10% of days rented or 14-day test under Section 280A. When a mixed-use exchange involving realty with both qualifying and personal usages (such as an operating farm with a personal residence eligible for IRC section 121) exists, these different usages should be addressed through contractual allocations of the price.
Real estate should be held for the long-term capital gain period of one year before disposition in order to satisfy section 1031’s requirement of being held for investment or business purposes. Any replacement property received in an exchange should also be held for more than a year.
Foreign realty is also not eligible for section 1031 treatment.
4. When is gain or loss recognized?
If an exchangor actually or constructively receives non-like-kind property known as boot (e.g., money or personal property) for the relinquished realty anytime before receiving the like-kind replacement property, the transaction is a sale and not a deferred exchange. As a result, the structuring of a deferred real property exchange requires documentation to support an interdependent and integrated transaction with the sale proceeds not being paid to the exchangor at the settlement date (or held in escrow).
The paper trail for this documentation should begin with the original purchase and sale agreement, which could contain a clause such as:
The seller reserves the option to convert the subject transaction to qualify under IRC section 1031 with the purchaser agreeing to cooperate in the execution of any of the required documentation (including but not limited to a four-party deferred exchange agreement and a qualified intermediary agreement), provided the purchaser shall incur no additional cost or liability.
5. What is the role of the qualified intermediary in an exchange?
The qualified intermediary (QI) is an entity or individual independent of the exchangor and not deemed to be its agent, either objectively or subjectively. Under the objective test, the QI cannot be the taxpayer’s closing attorney or anyone else who has had a business relationship with the exchangor during the last two years.
The QI is the recipient of the net proceeds from the closing of the relinquished property, with the money impounded for subsequent reinvestment into other realty. Any earnings on these monies may not be paid to the exchangor until the end of the exchange.
In a four-party deferred exchange, the QI is the fourth party, with the other three being the exchangor, the buyer, and the replacement property owner. These relationships are defined in the required documentation, executed with the buyer’s cooperation because of contractual requirements, using sample language described in question 4. These documents would include notice to the parties of the use of direct deeding, in which the exchangor would deed the realty being disposed directly to the buyer, while the replacement property owner’s deed would name the exchanging taxpayer as the grantee. The QI would not need to take legal title to the realty being relinquished or exchanged.
IRS Revenue Ruling 2002-83 prohibits a QI from using the impounded funds to acquire the property of a party related to the exchangor to be used as the replacement realty. Such a disposition by the related party would be deemed a sale under IRC 1031(f), precluding any party from cashing out during the two-year period following the exchange.
6. What time limitations apply?
The key date begins with the initial transfer date (ITD), which is the date of closing for the property being relinquished. Forty-five days from that date, there must be a formal identification of the choices for the replacement property.
The closing for the replacement property must occur no later than 180 days from the ITD (unless the due date of the individual’s tax return is earlier because the exchange occurs after October 17). While these time restrictions provide no extra days if this deadline falls on a weekend or holiday, practitioners should advise clients that the ITD can be postponed. This can be accomplished through a contractual provision for the buyer to have preclosing occupancy with a triple net lease feature; the closing date would be at the option of the exchanging taxpayer.
7. How must the replacement property be identified?
Replacement property is identified if it is—
The regulations permit more than one property to be identified as replacement property. As reflected in the Exhibit, the maximum number of replacement properties which the exchangor may identify under the regulations is—
Replacement property acquired during the 45-day period reduces the number of properties that can be identified under the rules above.
8. When may an exchangor receive money from an exchange?
The exchangor’s right to receive money or other property must be limited. These limitations provide that the exchangor may not, pursuant to the documentation, have a right to receive money or non-like-kind property until the earlier of—
Regardless of whether the exchangor subsequently receives money or boot from the QI at the end of an exchange, IRS Form 1099-S box 2 should be 0, and box 4 should be checked.
9. Can impounded funds held by the QI be used to pay closing costs?
The exchangor is not deemed to be in receipt of the funds to the extent that these are used to pay closing costs. The regulations indicate that the use of money held by a QI to pay transactional items will not result in the actual or constructive receipt by the exchangor of the remaining funds. This rule applies to costs that relate to the disposition of the relinquished property or acquisition of the replacement property, as well as expenses listed as the responsibility of a buyer or seller in the typical closing statement under local standards.
Examples of these expenditures include commissions, recording or transfer taxes, and title company fees. In addition, an exchangor’s right to receive items (such as prorated rents) that a taxpayer may receive as a consequence of the disposition of property and that are not included in the amount realized from the property transfer does not affect the exchange.
10. Can a real estate dealer take advantage of section 1031?
No. The property of a taxpayer can be excluded from section 1031 even though used in a business or for investment purposes, under the following circumstances:
11. What are diversification exchanges and consolidation exchanges?
Both the diversification exchange and the consolidation exchange refer to the fact that an exchange need not be a one-for-one transaction. In a diversification exchange, a taxpayer may be interested in diversifying his real estate portfolio either to reduce the risk associated with having property in one location or to provide smaller units of real estate for subsequent liquidation of a portion of the original investment. This is accomplished by exchanging one parcel for several.
In a consolidation exchange, the taxpayer has several properties but desires to simplify a portfolio, reducing the number of realty interests through section 1031.
Under both types, there must be strict adherence to the time limitations outlined in question 6.
12. Because the new realty normally has the same tax basis as the one relinquished, is it possible to increase the depreciation deductions available on the replacement property?
Even in situations where the exchangor has not added money to the acquisition of the replacement property, its basis can be increased. If the total liabilities on the replacement property exceed the debt that had existed on the relinquished property (assuming the taxpayer does not receive any cash or other non-like-kind property), the basis of the new property will increase.
The depreciation deductions can be increased when a nondepreciable asset is exchanged for a depreciable asset, such as vacant land exchanged for an apartment building. In addition, an exchangor could receive property which has a higher building-to-land ratio than the one transferred.
13. What are “build to suit” and “rehab to suit” realty exchanges?
The “build to suit” or construction exchange involves the acquisition by the QI of vacant land on which a structure will be built (i.e., not merely improving already-owned property owned by the exchangor). This results in pretax dollars from the QI’s impounded funds being used (which can be supplemented by proceeds from new debt financing). Upon the earlier of the completion of the project or the expiration of 180 days from the ITD, the portion constructed and considered as realty qualifies as replacement property, provided that the “as built” structure is substantially the same (in terms of completion) as what had specifically been timely identified under the 45-day rule.
The “rehab to suit” exchange is similar because the QI acquires realty which needs rehabilitation with pretax dollars being held by the QI.
In either case, the applicable documentation should utilize “time is of the essence” language, as well as address the issue of liquidated damages for purposes of ensuring the completion of the contractor’s work before the end of the exchange in order to avoid the receipt of boot. Documentation should also require sequential deeding (as opposed to the direct deeding referred to in question 5), in which the QI takes legal title as an interim grantee during the construction and rehabilitation period, eventually deeding the title to the exchangor before the expiration of the 180-day exchange replacement period.
14. How does the concept of the conversion of usage of realty apply to section 1031 exchanges?
The bona fide conversion of usage can benefit the only type of realty for which there is no favorable tax treatment under the IRC: vacation homes. This type of property (along with a personal residence in the rare case when the section 121 gain exclusion is inadequate) should be eligible for an IRC section 1031 exchange after a year of bona fide rental activity is reported on Schedule E of the taxpayer’s Form 1040.
The question that arises is: How long after an exchange can the replacement property received under section 1031 be converted to personal use without jeopardizing the individual’s original exchange? While there is no statutory, judicial, or administrative authority on this point, most advisers would recommend a substantial period of time (e.g., three years) before considering the conversion of business or investment realty to personal use. After this time, the taxpayer may then be able to qualify this property as a personal residence in order to take advantage of the IRC section 121 gain exclusion after subsequently satisfying the two-year holding period requirement.
15. Can an operating business be exchanged under section 1031?
Yes, when an exchange involves an operating business, section 1031 applies separately to both the realty and personalty (a “mixed property exchange”). Personal property is more difficult to configure under section 1031 because the definition of like-kind involves the concept of “like-class” under the Treasury Regulations. The resulting complexities in the tangible personal property area mean that office equipment and a business auto are not like-class and thus not like-kind. With respect to the business’ intangible property, goodwill of one operating business cannot be exchanged for that in another. As addressed in question 4, it is important to attempt to match allocations (based on fair market value) between the relinquished property and the acquired property. Consequently, there is a need to establish exchange categories that can qualify (e.g., realty and like-class personal property) and those that are never eligible (e.g., goodwill and inventory).
16. What is a “Reverse Starker” exchange?
A “Reverse Starker” exchange occurs when a taxpayer needs to either contract or acquire the replacement property before the title closing for the property being relinquished. Revenue Procedure 2000-37 provides a set of safe harbor guidelines:
17. How does seller financing affect a section 1031 realty exchange?
The following are the implications when a purchase money mortgage is received in an exchange:
18. What happens when the owners of partnerships and multimember LLCs disagree on the disposition of the entity’s realty?
Even when the sole asset of a partnership or LLC is realty, the interest in the entity is considered to be a form of intangible personal property in the hands of the partner or member. Accordingly, an exchange of an interest in an entity-holding realty for real estate is not considered the exchange of like-kind assets. In addition, the holding period (for purposes of calculating the timeframe discussed in question 3) for any realty distributed from an entity to its owners will begin upon receipt of the property.
When a partnership wishes to dispose of realty, there may be a difference of opinion between partners who wish to reinvest under section 1031 and those who wish to cash out. One solution is to have those partners who desire to remain in the partnership make a liquidating distribution to the others. Provided there is no technical termination of the partnership, the partners cashing out can receive consideration for their partial interests, while the remaining partners take advantage of section 1031, with the partnership as the exchanging taxpayer.
Revenue Procedure 2002-32 has recently provided insight in the area of partial realty interests or undivided fractional interests (UFI), which are being considered either as the replacement realty or as the property to be relinquished in an exchange. Revenue Procedure 2002-32 addresses the prerequisites for submitting a Private Letter Ruling request to the IRS regarding a nonpartnership tenant in common (TIC) arrangement by noting:
As a result of the limitations contained within Revenue Procedure 2002-32, advisers may want to consider a master lease for multitenant property that provides for a sublessor (such as the sponsor packaging the TIC interests) to pay a net lease amount to the co-owners.
Several recent private letter rulings have permitted taxpayers disposing of individually owned realty to receive the membership interest in a single-member LLC that owns the replacement real property. This arrangement may be beneficial to taxpayers concerned about liability exposure. The use of LLCs as the preferred entity for realty holdings is discussed in two of the author’s previous articles, “Twenty Questions on Selection of a Legal Entity” (The CPA Journal, August 1999) and “Twenty Questions on Protecting Business and Family Assets” (The CPA Journal, February 2000).
Though the subject article emphasizes deferred section 1031 exchanges undertaken by individual taxpayers, all of the various types of business organizations, including trusts, are able to utilize section 1031 by disposing of entity-owned realty and later acquiring replacement real property.
19. Is there an alternative to IRC section 1031, particularly when the real estate is held by a partnership or LLC?
An alternative to section 1031 exchanges is the use of an umbrella partnership real estate investment trust (UPREIT), which involves a tiered ownership structure encompassing a realty operating partnership (OP) and a REIT that is a partner in the OP.
Property owners wishing to divest their realty can contribute their property to the OP and, pursuant to IRC section 721, receive a tax-free partnership interest in the OP. This interest is convertible after a period of time into cash or shares of the REIT. When there is a liability-over-basis problem with respect to realty contributed to the OP, consideration should be given to the transferors guaranteeing a portion of the underlying property debt held by the OP. (For more information, see “Planning for UPREIT Transactions When Selling Partners Want to Go Their Separate Ways,” Journal of Taxation, April 1999.)
20. How can a charitable remainder trust be used as an alternative?
If a taxpayer wishes to avoid taxes on the disposition of real property and does not wish to take advantage of section 1031 (or has not utilized a self-directed IRA for the holding and tax-free dispositions of realty), there is another option. Prior to the execution of a contract to sell highly appreciated realty held for investment or business purposes, a taxpayer may consider donating this property to a newly created charitable remainder trust (CRT). This CRT will then sell the property and avoid capital gains tax. The CRT would pay an income for the life of the original owner based upon the pretax value of the donated property. This income stream is usually higher than that which would be obtained by reinvesting the after-tax sale proceeds in a certificate of deposit from a taxable transaction. Not only are the sale proceeds removed from the taxpayer’s estate, there is also the benefit of a charitable income tax deduction for income tax purposes (subject to the AGI limitations, with a five-year carryover period for any excess) based on the actuarial value of the remainder interest received by the charity.
A wealth replacement trust (WRT) may be used in conjunction with a CRT, since the latter does not provide any benefit of the trust principal to family members (i.e., the remainder is directed to charity). As a result, the life insurance industry developed the concept of having a portion of the tax savings/cash flow obtained from the CRT applied toward the purchase of life insurance (such as a second-to-die policy) that is held by the WRT as applicant, owner, and beneficiary of a policy insuring the husband and wife as grantors. The WRT is similar to a life insurance trust with a “Crummey” feature (see “Answers to 20 Questions on the Use of Trusts,” The CPA Journal, September 1998). Upon the death of the insured, the insurance proceeds held by the trust are used to replace the wealth that has been “lost” to charity.
IRC section 1031 offers a number of opportunities because of its flexibility. Nevertheless, tax cases have consistently indicated that the required documentation (along with the procedures for implementing a deferred realty exchange) must be, in the words of the courts, “bulletproof” in order to avoid problems at an IRS audit
Peter A. Karl, III, JD, CPA, is a partner with the law firm of Paravati, Karl, Green & DeBella in Utica, N.Y., and a professor of law and taxation at the State University of New York—Institute of Technology (Utica-Rome). He is also the author of www.1031exchangetax.com.