| Tax Free Like-Kind
Exchanges - Internal Revenue Code Section 1031
INTRODUCTION
An
important exception to the Internal Revenue Code's general rule
requiring recognition of gain or loss on disposition of property is
Section 1031, which permits the exchange of qualifying like-kind
property without total recognition or partial recognition of
realized gain or loss. In order to qualify for Section 1031
nonrecognition, both the property transferred and the property
acquired must be held for productive use in trade or business, or
for investment.
Like-kind
refers to the "nature or character of the property and not its
quality." For example, real property such as a shopping center may
not be exchanged for personal property such as stock in a
corporation, because the nature and character of the exchange
properties are not the same or like-kind. The property or properties
being exchanged must be like-kind in nature requiring that property
held for productive use in trade or business or for investment be
exchanged for other property held for productive use in trade or
business or investment.
When
nonqualifying or nonlike property (boot) is also received, gain must
be recognized to the extent of the boot received. Only the amount of
realized gain that is not recognized in a Section 1031 exchange is
deferred until there is a subsequent taxable disposition of the real
estate.
The
Internal Revenue Service requires mandatory utilization of the
nonrecognition provisions of Section 1031 when the following three
requirements are met:
(1) both
the property given and the property received are qualifying
properties;
(2) the
transferror gives and receives property; and
(3) the
properties exchanged are of like-kind in nature.
Qualifying
Property
Section
1031 property must be held by a taxpayer for use in a trade or
business or for investment before and after the exchange for it to
qualify for nonrecognition in a like-kind exchange. Therefore,
dealer property (property held primarily for the sale to customers
in the ordinary course of business or as inventory) is precluded
from Section 1031 treatment. Once the like-kind requirement is met,
and so long as the acquired property is held for productive use or
for investment, the acquired property need not be put into the same
use as the transferred property.
Property Held for
Investment
The
term "investment" is not clearly defined in the Code, although the
Regulations state that property held for future use with any eye to
appreciation, is property held for investment. The mere holding of
property for a number of years, however, is not conclusive of an
investment.
Like-Kind Real
Property
With
respect to “like-kind”, the statute requires that both the property
transferred and the property received be held either for use in a
taxpayer's trade or business or for investment, and that the
qualifying property be of "like-kind". The definition of real
property includes virtually all types of property, including land.
For example, the Regulations state that unimproved real property may
be exchanged for improved real property, and unimproved property is
like-kind to buildings without land. An undivided interest as a
tenant in common may be exchanged for a fee simple absolute.
Exchanges of ownership interests in real property are like-kind for
purposes of Section 1931(a), as are exchanges of remainderman
interests.
Mineral
rights are considered real property if state law so provides.
Leasehold interest of 30 years or more may be exchanged for a fee
interest in real property. A purchaser's interest under a purchase
contract for real estate may be exchanged for a fee interest in real
estate.
Transactions Involving
Boot
Taxpayers
must be aware of two basic concepts concerning "boot" that raise a
number of considerations. First, a taxpayer who under a
Section 1031 like-kind exchange, receives money or other
nonlike-kind property (i.e., boot) must recognize any realized gain
to the extent of boot received; boot transferred is not subject to
the Section 1031(a) nonrecognition rule nor the Section 1031(b)
partial recognition rule. In addition, the receipt of boot does not
create gain where none has been realized, but if gain is realized,
the receipt of boot causes recognition of gain, which would
otherwise be deferred under the general rule of Section 1031(a) to
the extent of boot received.
The
receipt of money, nonqualifying property, or property which is not
like-kind to the property exchanged, are all situations which
constitute the receipt of boot. Second, when the transferee
assumes the liability of the transferor, or acquires the property
subject to a liability as part of the consideration for the
exchange, such mortgage relief is treated as money received, and
therefore, boot.
Deferred
Exchanges
An
exchange of one piece of real estate for one or more replacement
pieces of real estate need not take place simultaneously under
Section 1031. Often, delays may be caused by difficulties in
locating or obtaining the replacement property. Since the Tax Reform
Act of 1984, delayed or "deferred" exchanges can qualify for
like-kind treatment as long as the replacement property is
identified by the taxpayer within 45 days of sale of the
relinquished property and received by the taxpayer before the
earlier of 180 days after the transfer, or the due date of the
taxpayer's tax return for the year in which the transfer occurs.
After the taxpayer has relinquished the exchange property, he will
want to secure in some way the transferee's obligation to complete
the exchange. However, in attempting to secure the transferee's
obligation, constructive receipt concerns are raised. If the
taxpayer actually or constructively receives money or nonqualifying
property in the full amount of the consideration for the
relinquished property before he receives the like-kind replacement
property, the transaction will be characterized as a sale and not a
deferred exchange even though the taxpayer may eventually receive
replacement property.
"Starker
Trusts"
The
accepted means of avoiding constructive receipt by the seller is to
place the funds into a trust, often referred to as a "Starker
Trust." The settlor, or person contributing the assets to the trust,
is the buyer. The trustee is a third party, which may be an escrow
company or trust company, and the beneficiary of the trust is the
taxpayer/seller, who seeks to effectuate the Section 1031
exchange.
The
mainstays of the trust agreement are the 45-day and 180-day time
periods provided in Section 1031. In the event the taxpayer fails to
designate property within 45 days and/or fails to cause the trustee
to purchase the designated property within the 180-day period (or
the due date, including extensions, for the taxpayer's return,
whichever first occurs), the transferor will receive all of the cash
held in the trust. However, the trust agreement specifically states
that until the occurrence and/or failure, as the case may be, of the
45-day and 180-day periods, the taxpayer will have no right to
withdraw, pledge, assign, or otherwise encumber the trust proceeds
or assign his rights under the trust agreement. In addition, the
trust agreement is irrevocable, which also protects the taxpayer
from any claims of constructive receipt.
Procedurally,
the trust agreement provides for the trustee to purchase and take
title to the designated property, with a subsequent transfer of the
property by special warranty deed to the taxpayer. However, it is
not uncommon and is acceptable for the taxpayer to instruct the
trustee to cause a single deed to be executed from the seller of the
designated property directly to the taxpayer.
PLANNING FOR LIKE-KIND
EXCHANGES
Requirements of Like-Kind,
Holding Intent and Exchange
The
fundamental requirements:
1.
You need a written exchange agreement between an intermediary or
buyer and taxpayer evidencing the obligation of the intermediary or
buyer to undertake an exchange.
2.
You must have held the property pelinquished for investment or for
use in a trade or business at the time of the exchange and you must
hold the target property for investment or use in a trade or
business.
3.
Real property must be exchanged for real property.
4.
You must identify the property within 45 days and acquire the
property within 180 days (exchange period).
Identification
1.
How to identify a property.
(a)
You must unambiguously describe by street address, legal
description, assessor's parcel number or distinguishable
name.
(b)
You may identify real property and exclude other property to be
acquired in connection with the real property if the other property
does not exceed 15% of the value of the real property and if such
other property is transferred with the larger item in standard
commercial transactions.
For example, if you are to acquire
an apartment building that also contains washing machines, you are
not required to identify the apartment building and the washing
machines. However, the receipt of the washing machines will not be
treated as like-kind with the real property traded so there may be
recognition of gain up to the value of the washing machines. You
should allocate a purchase price for the personal property so|d in
connection with an exchange in order to identify the amount of boot
that may arise in the exchange.
(c)
You must identify with the intermediary, in writing, the properties
you wish to acquire within 45 days after the initial transfer of
your property. If there is more than one property being transferred
as part of the same deferred exchange, the identification period
begins to run with the first
transfer of property.
2.
How many properties can I identify?
(a)
You must meet one of three tests:
(1)
Three like-kind property
pule.
You
may identify three properties regardless of their value. Use a
street address, assessor's parcel number and legal
description.
(2)
The 200% Rule.
If
you cannot comfortably restrict the identification to three
properties, you may identify any number of properties provided the
fair market value of the target properties does not exceed 200% of
the fair market value of the property transferred.
(3)
If you identify more than three properties with valued in excess of
200% of the value of the property relinquished, you still properly
identified the target properties if you acquire 95% of the aggregate
value of the target properties by the end of the exchange
period.
(b)
Fair market value determination is based on gross fair market value
without regard to any liabilities at the following times:
(1)
For the 200% test, it is made as of the last day of the
identification period.
(2)
For the 95% test, it is made as of the earlier of the date the
property is received by you or the last day of the exchange
period.
(3)
For constructed improvements, it is made as of the date it is
expected to be received by you.
Recommendation: Use
the 200% rule only in situations in which you are trading a more
valuable parcel for a number of less valuable parcels. In other
instances, I recommend that you limit your identification of
property to 3 target properties.
3.
When to identify properties.
You
must identify property within 45 days after the transfer of the
first of the properties transferred in an exchange.
(a)
The property transfer occurs when the benefits and burdens of
ownership are transferred or received, which usually coincides with
deed recordation.
(b)
You cannot extend the 45 day identification period to take into
account a Saturday, Sunday or federal holiday.
(c)
You must identify target properties by written notice, except as
noted in paragraph 3(d) below. You can send the notice by fax, mail
or hand delivery. (Most exchange intermediaries will send an
executed acknowledgment by fax of receipt of your fax on the same
day so that you have this document for your records evidencing
timely property identification).
(d)
If you acquire like-kind property in connection with the exchange
before the end of the 45-day identification period, the property is
not required to be identified in writing.
4.
If you are within the 45 days after relinquishing your property and
you either incorrectly identified target property or wish to change
the selection of target properties, you may amend or revoke the
identification in writing at any time before the end of the
identification period by sending this revocation to the intermediary
before the end of the identification period.
Receipt of Identified
Property
1.
When:
You
must receive identified property before the earlier of 180 days or
the time for filing your return including extensions.
(a)
If the exchange occurs after October 17 of any year and you are an
individual, you will have to file an extension on your income tax
return in order to take advantage of the full 180-day
period.
(b)
If the exchange occurs after September 16 of any year and you
represent a corporation reporting on the calendar year, your
corporation will have to file an extension on its income tax return
in order to take advantage of the full 180-day period.
2.
What:
You
must receive property that is substantially the same as the property
identified.
(a)
Constructed property. If you wish to construct improvements on
property to be acquired, you must exercise great care in the
identification of those improvements.
(1)
If substantial changes are made in the property to be produced from
that identified, the property will not be treated as properly
identified.
(2)
The determination of whether you properly identified target real property occurs when the
construction is completed
even though the construction is completed while in your
hands.
(3)
The determination of whether you properly identified target personal property occurs when the
property is received. The
construction on personal property, unlike the construction on real
property, must be completed before receipt of the improved target
property.
(4)
Deviations from the description of the improvements in the
identification may result in the IRS challenging your identification
of the property constructed.
3.
The 75% Rule.
The
IRS regulations contain an example which the IRS is presently
treating as a rule. If you acquired 75% of the value of the property
identified, the target property received will be substantially the
same as the target property identified.
Recommendation: The
issue of value raises an unnecessary uncertainty, and you should be
specific as to the percentage of the target property to be acquired.
However, you may rely on this example if you acquire less than all
of the target property you identified.
Constructive
Receipt
There
are specific rules to follow in order to avoid being in constructive
peceipt of all of the funds held by the intermediary.
1. Requirements.
The
exchange agreement must limit your ability to receive, pledge,
borrow or otherwise obtain the benefits of money or other property
before the end of the exchange period unless:
(a)
You have not identified target property by the end of the
identification period.
(b)
You have received all of the target properties to which you are
entitled under the exchange agreement.
(c)
The occurrence of a material and substantial contingency
that:
(1)
Relates to the deferred exchange;
(2)
Is provided for in writing; or
(3)
Is beyond your control.
2.
Closing costs.
Using
the exchange proceeds for prorated taxes, recording or transfer
taxes and title company fees, will not result in constructive
receipt of the entire amount held by a qualified intermediary, trust
or escrow. However, if the agreement states that you are in receipt
of the funds to the extent that the funds are used to pay your
closing costs, you may avoid this boot by paying the transaction
costs separately.
3.
Prorated income and expense
items.
You
can disregard items that you may receive as a consequence of the
disposition of the property and that are not included in the amount
realized from the disposition of the property, such as prorated
rents.
4.
Return of deposits.
You
should use the escrow through which the property is acquired to
return any deposit.
5.
Receipt of nonlike-kind
property.
If
you are receiving property in the exchange which includes
nonlike-kind property, such as personal property, there is a
questions whether the intermediary may transfer that property to you
before the events described in paragraph
Reporting
Requirements
1.
For the year in which you complete your exchange, you must prepare
and file a Form 8824 which identifies the type of property
transferred and the dates of disposition, identification and
acquisition of properties.
2.
You must also report whether the exchange was between related
persons.
Documenting the
Exchange
While
particular forms or documents for a tax-deferred exchange are not
required under IRC section 1031, thorough and accurate documentation
of your exchange offers visible proof to the IRS, and if necessary a
court, that all requirements have been met. In addition, the
exchange must be reported on Form 8824 with the tax return for the
year the transfer occurred.
IMPROVEMENT EXCHANGE
An
improvement exchange allows you to sell your old property and use
that money to buy a property with part of your funds, and to use the
remainder of your funds to make improvements. There are a few
critical things that you need to know.
You Must Equalize Your
Exchange
The
first critical rule is that you only have 180 days from the closing of your old
exchange
to equalize your exchange. For example, you sell your old
property
for $2,500,000 and
you are thinking of buying unimproved property or property needing
repairs. The purchase price of
the target property is $1,750,000 and you plan to make repairs or
improvements costing $1,500,000. The total project will cost
$3,250,000. By the 180th day, you need to have at least $2,500,000
invested in the new project (both land and
improvements) to
equalize your exchange.
What Happens if You
Don’t Meet Your
Equalization Target?
If
you don’t meet your equalization
target
($2,500,000 in our example), you pay tax on the amount that you fall
short. Using our example, if you are only able to complete $500,000 of the
improvements by the end of your
180 days, you would pay tax on the difference of $250,000,
since the purchase
of the property for $1,750,000 and
the $500,000 of
improvements only totals
$2,250,000.
Once You Take Title to the Target
Property,Your Exchange is
Over
When
you take title to the property, your exchange is over, at least on that
property.
For this reason, you need someone, other than your self (or your
entity is the relinquished property is held by an entity), to take
title to the land and make the improvements. It may be possible for
the qualified exchange intermediary to take title to the
property.
The title would likely be in the name of a limited liability company (an
“LLC”) that is established
for just this purpose. The money for the purchase of the
property
and for payment of the improvement costs would come from your
exchange account that the
qualified exchange intermediary is holding. Normally, you still
would be able to select the contractors. The LLC will continue to
hold the property until the
improvements are completed, or
until the 180 day limit is reached, whichever first
occurs.
How Do You Identify the
Improvements on Your 45 Day
Letter?
Since
you (or your entity) will be taking title to the improved building
to complete your
exchange,
you need to identify this as such on your 45 Day Identification
Form. In most cases your identification will read something like
this: “Purchase of the 16 unit apartment building at 123 Main
Street, San Francisco, CA, for $1,750,000 with the following
improvements: new exterior facade
- $250,000; interior renovations to all units $500,000".
The
Improvements Must Be Completed to
Count
For
the improvement costs to count towards your 1031 exchange, they must be
completed. This means that you only want to include
improvements that can be completed
before the end of the 180 day period. Include only enough
improvements to equalize your exchange. In our example, even though
you are planning
$1,500,000 of improvements, you only want to
identify $750,000 of these since that is all that you require to
equalize your exchange. In our example we can assume,
for example, that the additional improvements after the target
property is received by you would be paid from the proceeds of a new
loan on or refinance of the target
property. | 
