Complex Issues Concerning Section 1031 Tax-Deferred Exchanges

Since 1921, the rules for qualifying and completing 1031 exchanges have gradually broadened and become less restrictive. Even so, there are do’s and don’ts as well as several gray areas of which taxpayers should be aware. The topics below could each be the subject of their own post. They are raised here to draw your attention, and to invite further discussion with your advisors, and the team at Accruit.

Holding periods

There are no standard or specific holding periods by which a taxpayer must abide for property to meet the definition of “like kind” or held for investment or business use (the only exception is Section 1031 of the Tax Code, with certain limited exceptions, prohibits exchanges where the taxpayer intends to acquire replacement property from a related party. Related Party is defined in I.R.C. § 267(b) or 707(b)(1) and generally covers exchanges between family members as well as exchanges between other entities where there is a high commonality of ownership. Related Parties , discussed below). Holding periods are, therefore, determined on a case-by-case basis regarding the taxpayer’s genuine intentions based in part on: (i) their reasons for acquiring, holding, and disposing of the property; (ii) the taxpayer’s primary occupation; (iii) previous 1031 exchange activity; and (iv) use of property. Generally, the longer the holding period the better. However, a taxpayer who is disqualified from utilizing the benefits of Section 1031 would not then qualify merely because of a long holding period. What the Code, the courts, and the IRS want to prevent is taxpayers holding property primarily for sale and attempting to defer their taxes utilizing Section 1031 (e.g., a builder of residential subdivisions).

Related parties

The current rules are complex and restrictive, and all potential related party exchangers are encouraged to seek the guidance of their tax and legal counsel. Selling a relinquished property to a related party as part of an exchange transaction may be acceptable, provided the related party holds the property for a mandatory 24-month holding period. Acquiring a replacement property from a related party with exchange funds may also be acceptable, if the related party does their own 1031 exchange and holds their replacement property for two years and does not “cash out” of that property. (Listen to Max Hansen discuss the intricacies of related party issues)

Different entities

Generally, to qualify for Section 1031 the same entity that transferred the relinquished property must acquire the replacement property. For example, if the old property is being sold by an LLC, the new property should be acquired by the same LLC. It clearly should not be acquired by another entity, which would be a completely different taxpayer. There are some limited exceptions in the event an LLC is a single-member LLC, and the new property is being acquired by a new LLC with the same single member as the former LLC.

A similar issue arises when spouses are involved in an exchange transaction. For example, if the old property is owned solely by Husband, the new property should not be acquired by Husband and Wife. Conversely, if the old property is owned by Husband and Wife, the new property should be acquired in the same fashion. There are some very narrow exceptions to these rules, which go beyond the scope of this newsletter.

Already owned property

The “like kind” requirement will not have been met if the taxpayer attempts to transfer any exchange value from the relinquished property into property the taxpayer already owns. For example, the taxpayer cannot reinvest the proceeds from the sale of a relinquished property into upgrades at taxpayer’s other property. Further, the proceeds from the relinquished property may not be used to pay down existing debt on taxpayer’s other property.

Refinance

It is generally accepted that the taxpayer can receive equity from the replacement property through the placement of a new loan (refinance). However, the taxpayer must not refinance the old or relinquished property “in anticipation” of an exchange by placing a loan on the relinquished property once the taxpayer has taken steps to dispose of such property unless the taxpayer: 1) uses those proceeds to acquire or improve the replacement property, and 2) has no actual or constructive receipt of such proceeds. It generally helps is there is a bona fide business reason for any refinance within the parameters of an exchange transaction.

Dissolution of a partnership

The Code is clear – partnership interests do not qualify for Section 1031 tax deferral. Yet taxpayers’ advisors routinely recommend the following strategy:

1. Dissolve partnership.
2. Create new entity (tenancy-in-common).
3. Distribute pro-rata share to individuals (previously partners).
4. The transfer of the relinquished property to the Qualified Intermediary, and the receipt of the replacement property from the Qualified Intermediary is considered an exchange. To be compliant with IRC Section 1031, the transaction must be properly structured, rather than being a sale to one party followed by a purchase from another party. Exchange individual tenancy-in-common interests at will.

Two fundamental problems arise from this advice:

1. The Code requires that property must be “held for productive use in a trade or business or investment.” This implies there must be a holding period, for tenancy in common interests distributed out of a partnership although, as discussed above, the holding period requirement is uncertain. (Read more about “Drop and Swap” exchanges)

2. If the new structure is construed by the IRS as merely a strategy or series of steps to avoid the exclusion pertaining to partnership interests, the exchange would be disallowed.

Terminating an exchange and receiving the net proceeds

Occasionally, a taxpayer wants or needs to terminate an exchange after the net proceeds have been transferred to the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary . Pursuant to the Treasury Regulations and a valid exchange agreement, the taxpayer may receive the net proceeds:

1. After the 45-day identification period if there are no properties identified, or
2. After the 45-day identification period but before the end of the 180-day exchange period if all identified properties have been acquired, or
3. After the 180-day exchange period.
4. Upon the occurrence of a “material and substantial” contingency that the taxpayer had provided for at the time of identification. (An example could be that the taxpayer identified the property subject to the ability to have the zoning changed before the end of the exchange period. Read more on the release of exchange funds)

Conclusion

If any of these issues is or may be present in your 1031 exchange, it is strongly recommended that you discuss them with your tax and legal advisors, and your qualified intermediary, as soon as possible. Accruit’s leadership team has over 170 years of combined experience in working with taxpayers and their advisors in structuring successful 1031 exchanges.

At Accruit, we handle all types of complex exchanges. Have a situation you'd like to speak to an expert about? No problem. We're happy to have a free, no-obligation consultation with you.