1031 Tax Library

Exchanging your property under the §1031 deferred exchange rules.

 If your transaction meets the requirements of §1031, no gain or loss will be recognized in the year of sale. However, see Lesson 3 for discussion of gain recognized from that part of the exchange that does not qualify for §1031 treatment. It's called net boot received. This book focuses on the §1031 exchange of real estate under the deferred exchange regulations.

The real estate exchange is an alternative to a sale and purchase. If you want to sell one piece of real estate and buy another, you should compare the tax results of sale and purchase with the tax results of exchanging. If your property has appreciated in value, an exchange could result in substantial tax savings because gain would not be recognized on the transfer. If, on the other hand, your property has decreased in value, it must be sold rather than exchanged if you want to deduct the loss.

Without the special provision of §1031 in the Internal Revenue Code and the related regulations, transfer of one property in exchange for another produces the same result as an outright sale. The fair market value of the property received after deducting expenses of sale is treated as the amount realized. The difference between this amount and your adjusted basis of the property given up is recognized gain or loss.

Caution: The nonrecognition of the gain or loss provision of §1031 is mandatory and must be applied. There is no election on your part. If your real estate transaction meets the requirements of §1031, gain is not taxed and loss cannot be deducted. In other words, even if you realize a gain or loss on the exchange, it will not be recognized for tax purposes.

What is a Like-Kind Exchange?

To understand §1031, you must look to its legislative design. Congress intended you will not recognize taxable gain or loss if the Replacement Property received is merely a continuation of your old property investment. To qualify, you must structure and complete your exchange transaction in accordance with the requirements of §1031. Your intent doesn't count — what you actually do is what determines if you qualify or not. However, if the transaction is ambiguous, the Courts will look to intent of the parties. See Stack Eleven—Step Transactions and Substance over Form Doctrines—for more discussion on this matter.

Section 1031 provides for nonrecognition of gain or loss if three conditions are met:

·Only property held for investment or use in your trade or business qualifies for §1031 exchanges. Both the property exchanged by you and the property received by you must be qualified. Personal use property such as your personal residence does not qualify. Nor does “dealer” property.

·The properties must be of like-kind. They do not have to be identical. This is a very broad definition. All qualified real estate is of like-kind with all other qualified real estate.

·There must be an actual exchange of properties. There can be a transfer of money with the qualified property. This will not disqualify the exchange. Taxpayers lose most tax cases involving exchanges because their transaction fails to meet the requirements of §1031 for a reciprocal transfer of property.

Special attention must also be given to the exchange of depreciable property that has appreciated in value. Since the basis of the old property is “substituted” into the new property, your depreciation deductions may be affected. On the other hand, a sale and purchase could result in a higher cost basis in the new property and higher depreciation deductions.

It is important to distinguish between the term “deferred” and “delayed”. Since the beginning, many exchange specialists have referred to all §1031 real estate exchanges as deferred exchanges even though the Internal Revenue Code referred to them (and other exchanges) as tax-free exchanges. It's really an issue of semantics. Many exchange specialists called exchanges using accommodators and facilitators delayed exchanges in an attempt to justify a time delay between the closing of the “sale” and the closing of the “purchase”.

At the IRS hearings for the dealing with deferred exchanges, the IRS was asked if they would consider using the term delayed exchange instead of deferred in the language of the regulation. They said no!

In saying no, the IRS explained they preferred the term deferred and defined it as an exchange in which the taxpayer transfers qualified property and subsequently receives qualified property in consideration. In fact, the regulation deals exclusively with deferred exchanges, addressing and making the rules defining the time restriction and identification requirements.

So we are all using the same terms to mean the same thing, the word “deferred” exchange refers to the exchanges defined in Reg 1.1031(k)-1.

Multi-Party Exchanges

Trading properties directly with the other party is called a two party exchange. The difficulty is rarely will you find two owners who each want the other's property. Normally, the other owner wants to sell. This presents a problem if you want to dispose of property to finance the acquisition of new property and avoid taxable gains that would substantially reduce your equity. If you could exchange tax-free for the desired property, you could get full benefit from your equity undiluted by income taxes.

The three-way exchange was a tax-inspired technique designed to solve the dilemma of a two-way swap. However, when one or more of the parties will not cooperate with the exchange, the delayed exchange should be used to put together a successful simultaneous exchange.

Until the deferred exchange regulations were issued, multiple-party transactions ruled. Most multi-party exchanges involved three and four party transactions. Some experienced exchangers put together transactions involving more than ten parties. Any part of these multi-party exchanges qualified as a like-kind exchange if it met all the requirements under §1031.

If you receive property in a like-kind exchange and the other party who transfers the property to you does not give you title—but a third party does—you can still threat the transaction as a like-kind exchange if it meets all the requirements of §1031.

There are three basic plans used to accomplish three-way exchanges—the courts have approved all. Keep in mind all these exchanges took place before the deferred exchange regulation was issued. Multi-party exchanges can be dicey. If one leg fails, your exchange can fail. In my opinion, the safe harbors provided by the deferred exchange regulation make it an easier and safer way to go.

Multi-Party Illustrations

For purposes of illustration, you want to acquire a new property and use the equity in your old property as partial payment. The owners of the property you want are not interested in a trade, they want a cash sale. You find a buyer for your property.

You—want to exchange your property.

Buyer—has cash and wants to acquire your property.

Seller—owns the property you want to acquire but does not want your property. Wants cash.

Here are three ways to accomplish the exchange and acquisition of the property you want.

Three-way Exchange 1 - Three Individual Transfers

Under this arrangement, Client transfers his property to Buyer, Buyer transfers cash to Seller, and Seller transfers his property to Client.

In W.D. Hayden Co. vs Commissioner, 165 F.2nd 588, the court held the taxpayer had exchanged one property for another even though Buyer made a cash payment to Seller. See also Rev. Rul. 57-244.

Three-way Exchange 2 - Exchange With Purchaser

Under this arrangement, Buyer acquires Seller's property for cash, and then exchanges it with you for your property. This arrangement will qualify you for 1031 treatment if, in fact, an actual exchange between you and the Buyer takes place. Furthermore, under the agreement, you must be obligated only to make an exchange and not a sale. In addition, to qualify, the Buyer must use his own funds to acquire the property from Seller.

It is not necessary for Buyer to take title to the property. Nor will the exchange fail because you carry out all negotiations.

Three-way Exchange 3 - Exchange With Seller

Under this arrangement, you exchange properties with Seller. Then, Buyer purchases the property from Seller. To qualify, Seller must take title for himself or as Buyer's agent.

In Leslie Q. Coupe, 52 TC 394, the court said, “The statute only requires that as the end result of an agreement, property be received as consideration for property transferred by the taxpayer, without his receipt of, or control over, cash.”

Three-way Exchange - Broker Acting As Accommodator

The Barker case (Earlene T. Barker, 1980 74 TC 555) is a good example and road map to follow in structuring a three-cornered real estate exchange through a fourth-party escrow holder. Under a series of interrelated contracts, fourth party (the accommodator) took title and received payments for all properties, then transferred title and cash among parties to carry out the exchange.

Under escrow agreements, successful closing of each transaction depended on successful closing of all others. This integrated agreement, and the fact that Barker had no option or right to take cash, guaranteed nonrecognition of gain under §1031.

Exchange Problems Before the Deferred Exchange Regulation

The difference between a successful exchange and a closed sale transaction with reinvestment of the proceeds in another property is critical. A great way to learn how to structure a successful exchange is experience and more experience. One way to get it is to read about how other people did it and what they did right—and wrong. The information in tax cases is powerful input. What did the taxpayer do right? Or what went wrong. Based on this input, we can ask ourselves this question? How can we arrange our transaction to make it successful?

Section 1031 requires an actual exchange of the properties. If you sell your property and reinvest the proceeds in the Replacement Property, you do not qualify for §1031 treatment. The Carlton case is a good illustration of this reality.

The receipt of cash instead of qualified property by Carlton transformed what was intended to be an exchange into a sale and purchase. However, in another case, a transaction that took the form of an exchange did not fail to qualify for nonrecognition merely because the “seller” was obligated to transfer his property for cash but, prior to the closing, exercised an option to accept like-kind property instead of cash.

In Joyce M. Allen, the taxpayers' attempted three-corner exchange did not qualify for nonrecognition of gain under §1031. The transaction was held to be a sale and a purchase. The two transactions were only related by the fact that proceeds from sale of one property were used to buy the other property. The court held the transfers of property were not steps in an integrated transaction and nothing in the records indicated the successful completion of either transaction was a condition of the other. If Allen's purchase escrow had failed, she would have ended up with the proceeds from the sale of her property.

Caution: You will not get §1031 treatment merely if you intend to exchange—you must actually exchange your property. The Anderson case speaks directly to this issue. The Court ruled that the sale of the Andersons' Los Angeles property and the purchase of property in Ukiah, California, did not qualify as a §1031 exchange because there was no connection between the sale and the purchase. Here are excerpts from the opinion:

“An actual exchange is nevertheless essential for nonrecognition under Section 1031. The taxpayer who sells property must recognize gain or loss, even if he immediately reinvests the proceeds of the sale in like-kind property. * * * * Moreover, the requirements of an integrated plan of exchange demands more than the mere unilateral intent of petitioners. Petitioners presented no evidence of the intent, or even the knowledge, of the . . . other parties . . . regarding a plan of exchange. In any event, mere intent to effect an exchange is insufficient to bring the transactions within the parameters of Section 1031. * * * * We recognize that, had the parties structured the transactions differently, petitioners could have obtained the benefits of Section 1031.”

The Problem of Constructive Receipt

The secret of a successful deferred exchange is avoiding receipt of money or other property during the transaction. If you receive the cash proceeds from the “exchange” of your property, you will not qualify for §1031 treatment. While this may sound easy to avoid, it's not. You must overcome the doctrine of “constructive” receipt. The general rules concerning actual and constructive receipt apply to determine if you are in actual or constructive receipt of money or other property before you actually receive like-kind Replacement Property. No regard is given to your method of accounting. However, there are four safe-harbors you may use to avoid constructive receipt. These safe-harbors are explained later.

You are in actual receipt of money or property at the time you actually receive the money or property or if you receive the economic benefit of the money or property. You are in constructive receipt of money or property at the time the money or property is credited to your account, set apart for you, or otherwise made available to you so you may draw upon it at any time. Or if you can draw upon it if notice of intention to withdraw is given.

You are not in constructive receipt of money or property if your control of its receipt is subject to substantial limitation or restrictions. However, you are in constructive receipt of money or property at the time such limitations or restrictions lapse, expire, or are waived. In addition, actual or constructive receipt of money or property by your agent is actual or constructive receipt by you.

Caution: The actual or constructive receipt rules provided here are only for use in determining whether there is actual or constructive receipt in the case of a deferred exchange. Don't use them for other real estate transactions.

In Leonard W. Sapp and Lola L. Sapp v. Commissioner, T.C. Memo. 1993-211.1, the Court ruled the Sapps did not have to recognize gain on a certificate of deposit in the year taken as part consideration of a real estate exchange. The Sapps agreed to sell real property. The sales price consideration was the exchange of a like-kind real property parcel, cash and a certificate of deposit. The like-kind property parcel received by the buyer was part of a rehabilitation project being arranged by the buyer and was to be partially financed by a development bond. However, as a condition of financing the overall transaction, the financial institutions involved in the transactions required the Sapps to pledge the certificate of deposit as additional security for the rehabilitation project undertaken by the buyer. The sales transaction would not have gone forward without the pledge agreement.

The Court said the certificate of deposit received by the Sapps as part of the proceeds from the sale was pledged as security in an interrelated transaction and was not includible in income because the underlying funds were not actually or constructively received by the Sapps. Release of the certificate of deposit was conditioned upon the buyer's showing that net operating income from its rehabilitation project exceeded 120% of debt service for 12 consecutive months. The Court said this condition was impossible to satisfy during the tax year in question since that was the year in which the sale and exchange occurred. The constructive receipt problem can be avoided by using the safe harbor provisions of the deferred exchange regulation. Not to use them is an unnecessary and foolish risk.

The Deferred Exchange

Here are two very important new terms used in the study and practice of deferred exchanges:

·Relinquished Property—the property being sold by the exchanger.

·Replacement Property—the property being acquired by the exchanger.

On April 25, 1991, IRS issued the long-promised regulations dealing with the time restrictions amendment made in 1984 to §1031. Before this, taxpayers had great difficulty structuring delayed exchanges. Multi-party exchanges, at best, were difficult and risky. And trying to sell the Relinquished Property before closing on the Replacement Property almost impossible. Unless the closing of the Replacement Property was contingent upon the successful closing of the Relinquished Property sale, the exchange was doomed.

The deferred exchange regulation—Reg 1.1031(k)-1—is a taxpayer’s dream come true. It can work without the buyer of your Relinquished Property or the seller of the Replacement Property getting involved in the exchange.

Since §1031 provides no gain or loss will be recognized in the exchange of like-kind real estate properties—you must actually exchange the properties. A reciprocal transfer. As crazy as it sounds, most exchanges challenged by the IRS lose their §1031 treatment and are held to be a sale and a purchase—two separate transactions. In other words, the taxpayer failed to make a §1031 exchange. The result is known as a taxable sale.

Unless you follow the safe harbors of the deferred exchange, or write a complicated agreement making the sale contingent on the successful closing on the Replacement Property, you cannot sell your property and reinvest the money—even if you do it concurrently. But two party exchanges are next to impossible—rarely will you find two owners who each want the other's property. Normally, the other owner wants to sell.

This presents a problem if you desire to dispose of property to finance the acquisition of new property but want to avoid selling your property in a taxable event. A sale would produce taxable gains and could substantially reduce your after-tax proceeds. If you could exchange your property tax-free for the desired property, you could benefit from the fair market value of your property undiluted by income taxes on the sale. In other words, you can use your entire equity before taxes to purchase the Replacement Property.

For example, you want an exchange. You find a buyer. You shop and find a Replacement Property that meets all your requirements including price. The stage is now set for the classic multi-party exchange. But the buyer of your property and seller of the Replacement Property refuse to get involved in an exchange. Or the buyer wants your property now and you have not yet located your Replacement Property. But if you sell your property and hold the money in a regular escrow account, you will fail the exchange test and pay tax on your entire gain. Each difficulty compounds another. What's a person to do?

The deferred exchange is designed to solve this dilemma. It permits you to “sell” your property now and use the proceeds to buy the Replacement Property later. As long as it's done following the rules with a Qualified Intermediary, you get §1031 treatment.

A deferred exchange is an exchange in which you transfer qualified property called the “Relinquished Property” and subsequently receive qualified property as consideration. The property received is called Replacement Property.

The IRS regulation explaining how to put together the §1031 deferred real estate exchange is one of the most powerful tools for selling appreciated business, farm, and investment real estate without recognition of gain for income tax purposes. It spells everything out—step by step. Just follow the rules and you can sell your appreciated property, use the cash proceeds to buy your Replacement Property and qualify for the full benefits of nonrecognition of gain under Section 1031. The regulation has the weight of law and all parties must follow it—even the IRS.

One of the outstanding features of the deferred exchange regulation is it establishes and defines the Qualified Intermediary (QI) as your vehicle to qualify for the safe harbor procedures you must follow to get non-recognition of gain treatment on your deferred exchange.

After the transaction is completed, you and your QI settle up. Your tax reporting of the exchange is easy to figure. You simply measure what you put into the exchange—Relinquished Property and boot—against what you take out after your settlement with the QI§—Replacement Property and boot.

Qualified Property of Like Kind

The first thing to do when considering an exchange of appreciated real estate is to determine if the property you are selling and the property you are buying qualify for §1031 treatment. This is key step.

Section 1031 exchanges are called by many names. Nontaxable exchanges, Like-Kind exchanges, and so on. But using the name like-kind can be confusing. To meet the requirements of §1031, both Relinquished Property and Replacement Property must qualify. In other words, both the property you are selling and the property you are buying must be qualified property of like-kind. If not, your exchange will fail and be classified as a sale.

For income tax purposes, real estate is divided into four classifications. Classification is made as of the date the transaction is made. The classifications are:

Held for business use (§1231)

Held for investment (§1221)

Held for personal use

Held primarily for sale (dealer property)

The first two classifications—held for business and held for investment—qualify for §1031 treatment. The second two—held for personal use and dealer property—do not.

The property you trade away is called Relinquished Property. The property you receive is called Replacement Property. You must actually own the Relinquished Property and must acquire ownership of the Replacement Property.

In Chase v. Comm., 92 TC 874 (1989), §1031 treatment was denied where a partnership-owned building was exchanged for a building that went directly to some of the limited partners. This was not eligible for 1031 treatment since neither the partnership nor the partners were owners on both ends of the transaction.

Four Classifications of Real Estate

Real estate held for personal use.

Real estate held for use in a trade or business.

Real estate held for investment.

Real estate held primarily for sale to customers in the ordinary course of business.

Some properties have more than one classification at the time of sale. For example, a farmer sells his farm including his personal residence. The sale or exchange is allocated between the real estate held for personal use (the personal residence) and the real estate held for use in a trade or business (the farm). Another example is the sale or exchange of a duplex where the seller lived in one unit and rented out the other unit. The sale would be allocated.

Real Estate Held for Personal Use

This classification includes your primary residence, vacation homes and other property held for personal use. Your primary residence includes the dwelling unit and the land it's located on. The land alone, however, is not a residence. Land included with the sale of your personal residence might present an allocation problem. The question is—how much land can be sold with your personal residence and qualify for §121 exclusions? IRS has issued no definitive rules. Rather, each case is looked at separately. In Rev Proc 87-3, IRS says whether or not an owner uses property as a personal residence depends on all the facts and circumstances in each case, including the good faith of the owner. If any of the land is used for business or held for investment at the time of sale, an allocation of classification must be made.

The IRS and court cases have allowed up to 65 acres of land to be included as part of the residential classification. However, the rules indicate that more acres could be included if the facts and circumstances so warrant.

If real estate held for personal use is sold at a gain, gain not excluded under §121 is treated as a capital gain and subject to tax. If sold at a loss, the loss is personal and not deductible.

Exchange Treatment - Real estate held for personal use does not qualify for §1031 like-kind exchange treatment.

Interest paid to acquire a personal residence and one second home may be deducted as home mortgage interest if otherwise qualified.

Real Estate Held for Use in a Trade or Business

This property is known as §1231 real estate. There are two types of real estate used in a trade or business:

·Owner occupied and the property is used in the owner's trade or business.

·Rental income property. The act of renting the property qualifies it as property used in a trade or business.

Net gains from the sale or exchange of §1231 property are taxed as long-term capital gains. However, if the holding period is short, the gain may be recognized as ordinary income. Net losses are deductible as ordinary losses.

Exchange Treatment - IRC Section 1231 property qualifies for §1031 like-kind exchange treatment.

Interest paid to acquire §1231 real estate is deducted as business interest against the operation of the real estate business activity.

Real Estate Held for Investment

Investment real estate is a capital asset (IRC Section 1221). It's property held primarily for appreciation of value due to location, passage of time and other factors outside the activities of the owner. It is treated as a portfolio investment asset. An example of investment real estate is raw land held for appreciation. Even if purchased with the idea you might someday develop the property, if you don't develop it (for any reason), the property will not lose its classification as investment property.

Real estate used in a trade or business is not held for investment. Real estate held for personal use is not held for investment. If you have trouble understanding this, you are not alone. Many real estate people have trouble with this. After all, they have been selling property for years as a good investment. But remember, we are dealing with taxation here—not financial investments. The tax treatment of investment property is different than the tax treatment of business property—and the differences are profound.

If sold at a gain, the gain is a capital gain. If sold at a loss, the loss is a capital loss subject to the capital loss limitation rules.

Exchange Treatment - Investment real estate qualifies for §1031 like-kind exchange treatment.

Interest paid to acquire §1221 property is treated as investment interest and may be subject to special deduction limitations.

Real Estate Held for Sale to Customers

This classification is known as dealer property. To be classified dealer property, the property must be held at the time of sale or exchange

·primarily for sale

·to customers

·in the ordinary course of business.

All three elements must exist at the time of sale or exchange or the property will not be classified dealer property. Primarily for sale means of the first importance. It does not have to constitute more than 50% of the purpose—it need only be the most important. The Supreme Court said, “If an owner acquires a property for rental or investment use, but also plans to sell the property and realize gain in any way he can if the original plan becomes unfeasible, he does not hold the property primarily for sale.”

All buyers of real estate are customers as the term is used here. The activity “in the ordinary course of business” must be directly related to the sale of that property. In addition, the activity must be “busy”. The two “busy” activities usually related to a sale or exchange are

sales activities related to the property, and physical improvements to the property.

Many people, including many IRS agents, misunderstand this activity. To be classified dealer property, there must exist a busy business activity directly related to that property. If you buy a parcel of land, subdivide it, and build houses for sale, there's no question you have dealer property. But if you buy a parcel of land, make no physical improvements, subdivide it by getting it rezoned and meeting other legal requirements, and sell it in the form of an unsolicited offer—you get capital gain treatment. The reason? No business activity related to the property.

If the property is listed with a licensed real estate broker, the sales activities of the real estate broker are not considered to be the sales activities of the owner.

The Tax Court has held the real estate activities of corporations owned or controlled by an individual cannot be attributed to him even though he may be engaged full-time as an officer of the corporation.

Licensed real estate brokers and salespersons ordinarily are not dealers. In Scheuber v. Com. 371 F2nd 996, it was held properties purchased by a licensed real estate broker (who intended ultimately to sell) and held for realization of appreciation in value over a substantial period of time were capital assets.

If dealer property is sold at a gain, the gain is taxed as ordinary income. If dealer property is sold at a loss, the loss is deductible as an ordinary loss.

Exchange Treatment - Dealer property does not qualify for 1031 like-kind exchange treatment.

Interest paid to acquire dealer property is deductible as business interest against the dealer property activity.

Excluded Property

If all or some of the property you want to sell does not qualify for §1031 treatment, a transfer of that property in an exchange transaction will be treated as a sale of that property.

§1031(a) excludes these assets from nontaxable treatment:

Stock in trade

Property held primarily for sale

Stocks

Bonds

Notes

Choses in action (accounts receivable)

Certificates of trust or beneficial interest

Securities or evidences of indebtedness

Caution: It doesn’t matter if any of the excluded property items are related to real estate; they are always excluded from §1031 treatment. For example, a note can never qualify even if secured by real property.

Held for Productive Use or Held for Investment

For an exchange to be tax-free, both the Relinquished Property and the Replacement Property must be “qualified”. Qualified means held by you either for productive use in a trade or business or for investment.

Examples of property used in a trade or business are farms, ranches, rental income properties, industrial and commercial properties used by the owner in his business. All real estate qualifying for depreciation under Code Section 167 is deemed property used in a trade or business. This property is described in Code Section 1231(b).

An example of real property held for investment is unproductive land. Unproductive real estate held for future use or future realization of the increment in value is held for investment and not primarily for sale.

Two or more qualifying properties can be received in exchange for the transfer of a single property. Likewise, business property may be exchanged for investment property and vice versa. Qualifying newly constructed property can be exchanged for used property.

Properties can be “mixed” and qualify. For example, I exchange my duplex rental property and a lot I have held for investment for your farm. We both may qualify for §1031 treatment. There is no requirement your former property be held for business or investment use by the other party to the exchange. What the other party does with your property will not affect the tax-free status of the exchange for you.

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Like-Kind Property

Like-kind is one of the most misused terms in real estate exchanging. Many use it to include the qualifying property requirement. Not so. Be sure not to confuse the term ‘like-kind’ with the term ‘qualified property’. The property must meet both definitions to get §1031 treatment.

The regulations broadly define the term “like-kind.”

“As used in Section 1031(a), the words 'like-kind' have reference to the nature or character of the property, and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale.”

Real estate located in the 50 United States is of like-kind when exchanged for other real estate located in the 50 United States. The definition of “50 United States” means exactly that. It does not include foreign real estate described later in this stack.

Here are some examples of like-kind:

Improved real estate for unimproved real estate.

A leasehold of a fee with 30 years or more to run for real estate. For this purpose, optional renewal periods may be added to the initial term of the lease. See Sale-Leasebacks as Exchanges in Lesson Nine.

A fee interest in unimproved land for a fee interest in unimproved property subject to long-term income producing condominium leases.

A perpetual water right treated as real property under local law for a fee interest in land.

In LTR 9851039, the Internal Revenue Service ruled  the exchange of an agricultural conservation easement for a farm property qualifies as a tax-free exchange under Section 1031(a).

Timberlands differing in quality and quantity of timber.

Timberland, with a reservation of timber cutting rights, for timberland.

A remainder interest in farmland for a remainder interest in another parcel of farmland.

Fee Interest Exchanged for Remainder Interest—In Ltr Rul 8950034, the parties to the exchange were a trust and a corporation. The corporation had one class of stock. The trust owned most of the shares. The adult son of the trustor owned the rest. The corporation owned a parcel of land that it held as income producing rental property. The trust owned a parcel of property also held as income producing property.
 

The trust proposed to convey to corporation the property on which its headquarters was located in exchange for a vested remainder interest in the property owned by the corporation. After the exchange, the corporation would continue to use the property it gets in the exchange in its business. The trust would hold its interest in the property it gets for investment. It would hold it as an income producing property when it ripens into a possessory interest at the end of a seven-year period.
The IRS said the term "like-kind" refers to the nature or character of the property, not to its grade or quality. Therefore, certain factors, such as whether the property is improved or unimproved, are not relevant. The IRS said the nature and character of properties exchanged by the trust and corporation would constitute like-kind property. Because the nonpossessory interest would become a possessory interest and therefore, a fee interest, the rights vested in the parties were substantial.

Farm land belonging to an incompetent for other farm land, even though the exchange took the form of a cash sale and purchase because it involved an incompetent and local law permitted no exchanges by guardians. Rev Rul 59-229

Some interests in realty are so dissimilar that an exchange is not treated as like-kind property. Examples include the exchange of leasehold for a fee title unless the lease has 30 years or more to run. It includes the exchange of overriding oil royalties for a fee title. If a mineral interest is exchanged for other property, but the grantor retains a production interest in the minerals, the transaction is considered to be a lease rather that a sale. The property received in the exchange for the mineral interest will be treated as a lease bonus and taxed as ordinary income. (Crooks v. Comm., 92TC816) (1989)

Real estate is a highly complex asset and exceedingly difficult to classify in many exchanges. In Rev Rul 55-749, the IRS said the exchange of land for perpetual water rights qualified as like-kind where the water rights were treated as real property under state law.

In LTR 9851039, the Internal Revenue Service ruled the exchange of an agricultural conservation easement for a farm property qualifies as a tax-free exchange under Section 1031(a).

In Rev Rul 92-105, the IRS said a taxpayer's interest in an Illinois land trust would qualify as property of like-kind if exchanged in a §1031 exchange transaction. (Under Illinois law, land trusts can hold title to real property located in the state.) The ruling went on to say the same result would apply to similar arrangements under the laws of states having statutorily or judicially sanctioned arrangements similar to the Illinois land trust. These states are California, Florida, Hawaii, Indiana, North Dakota, and Virginia.

A land trust is a legal arrangement where the trustee holds title to real property. The beneficiary has exclusive power to direct or control the trustee in dealing with the title to the property. In addition, the beneficiary has exclusive control of the management of the property and the exclusive right to the earnings of the property.

A land trust arrangement usually includes a deed in trust and a land trust agreement. The deed transfers title to a trustee subject to the provisions of the land trust agreement. The land trust agreement authorizes the trustee to deal with the legal title to the property. The beneficiary keeps exclusive control of operating, buying, renting, and selling the property. Filing tax returns, paying taxes and other liabilities is the duty of the beneficiary.

The IRS said the exchange by the beneficiary of his interest in the land trust is an exchange of the underlying real property. It is not an exchange of beneficial interest or certificate of trust. Since the underlying property and the Replacement Property are like-kind, the exchange falls under the provisions of §1031.

Tax Case:  Dave owned a farm. One day a state agency called him and wanted to buy an agricultural conservation easement on his farm. The easement was treated under state law as an interest in land and defined as the right to prevent the use of the land for any purpose other than farming. Dave said OK but instead of selling and paying capital gains tax, he wanted to exchange for a fee simple interest in another farm. However, the state could not enter into an exchange agreement. So Dave signed an exchange agreement with a qualified intermediary. Under the exchange agreement, the intermediary acquired the farm Dave wanted and exchanged it with Dave for the easement. The intermediary sold the easement to the state and used the proceeds to buy the replacement farm conveyed to Dave. Cash boot paid and received by Dave was subject to the regular boot rules under §1031.

All requirements of the qualified intermediary safe harbor rules (Reg 1.1031(k)-1) were met and the property was of like-kind. Dave qualified for §1031 treatment, and got a deferred exchange. See IRS Letter Ruling 9232030.

Real Estate Options

Options to buy or sell real property must be considered in §1031 tax planning. Depending on the classification of the underlying real property, an option may qualify for §1031 treatment.

An option contract may be:

a binding agreement by the owner of real estate giving another the right to buy the property at a fixed or determinable price within a specified time, or

it may be a binding agreement by the owner of property and another giving the owner the right to sell the property to the other person at a fixed or determinable price within a specified time.

A right of first refusal is not an option. Nor is executory contract to sell land in the future.

Gain or loss on the sale or exchange of an option takes on the same character as the underlying property; it is considered gain or loss from the sale or exchange of property. The option contract takes on the same classification as the property (to which it relates) would have if acquired by the optionee buyer.

A taxpayer granted another party an option to purchase property. The property qualified for like-kind treatment in the hands of the taxpayer. The other person exercised the option by transferring like-kind property to the taxpayer. IRS said it was a good like-kind exchange because both the Relinquished Property and Replacement Property were used in the taxpayer’s business. The transaction did not qualify as a like-kind exchange for the other party. The property he transferred to the taxpayer was acquired solely for the purpose of making the exchange and not held for use in a trade or business or held for investment. Arthur E. Brauer, 1980 74 TC 1134

An option is an agreement between a seller (optionor) and a buyer (optionee) to keep open, over a set period of time, an offer to sell property. It's a unilateral agreement imposing an obligation only on the seller. He must sell if the buyer exercises the option. But the buyer is not obligated to buy the property if he chooses not to.

People use options because they offer advantages to both buyer and seller. They give the buyer time to decide if he really wants to buy the property and arrange financing. They give the seller compensation for taking the property off the market during the option period.

The option must be supported by its own consideration, separate and independent of the purchase price of the property. It creates a contractual right and does not give the buyer any estate in the property. When the buyer acquires an option to buy real estate, he gets the right to buy the property at any time within a specified time period at the price specified in the option. What he pays for the option depends on the circumstances, but it will be small compared with the selling price of the property. If the buyer fails to exercise the option, he loses the amount he paid for it.

Options involve tax consequences for both parties. Two issues are involved: when is tax imposed and is the gain a capital gain or ordinary. Tax may also be incurred if the option is sold or exchanged.

Tax Treatment of Options-Seller

The seller's receipt of compensation for granting an option is treated as a nontaxable event. The rule applies if the option money is applied against the sales price of the property. However, option payments do not lose their nontaxable character merely because they are not offset against the purchase price. The transaction stays open until the option is exercised or forfeited.

At that time it is possible to determine how the option money should be treated tax-wise.

If the buyer exercises the option, the option money is considered part of the sales price of the property and treated as a down payment in the year of sale. If the sale is an installment sale, the option money (no matter when it was paid) is treated as payment in the year of sale and part of the contract price.

If the buyer forfeits, and does not exercise the option, it is treated as a sale of the option by the seller on the date the option expired. The option money becomes ordinary income to the seller. The ordinary income rule applies to all sellers including dealers and investors.

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In Carl E. Koch, 67TC 71, the Court held that payments under an option expressed as a percentage of the purchase price were not taxable as interest.

Tax Treatment of Options - Buyer

Reminder: Gain or loss from the sale or exchange of an option contract is considered gain or loss from the sale or exchange of property. The option contract takes on the same classification as the property (to which it relates) would have if acquired by the optionee buyer.

Business Property (§1231)—If the underlying property would have been business property in the hands of the optionee, the gain or loss is subject to §1231 treatment. To qualify, the option must have been held for more than one year. Under Section 1231, gain is treated as long-term capital gain. Loss is treated as ordinary loss.

If the holding period of the option is one year or less, gain is treated as ordinary income. Loss is treated as ordinary loss.

Investment Property (§1221)—If the underlying property would have been investment property in the hands of the optionee, capital gain or loss is realized. If the option was “held” for more than one year, the capital loss is long-term. If one year or less, short-term.

Personal Use Property—If the underlying property would have been real estate held for personal use in the hands of the optionee, gain is treated as capital gain. If a loss is suffered, it is personal and not deductible.

[2-3]

Dealer Property—If the underlying property would have been real estate held as property for sale to customers in the ordinary course of his trade or business by the optionee, any gain is treated as ordinary income. Any loss is treated as a deductible ordinary loss.

Not Held for Resale

If one of the properties in an exchange is held primarily for sale, the exchange of that property does not qualify for §1031 treatment. Held primarily for sale is not limited to dealers. Property was deemed held primarily for sale and not for investment where it was sold under a “prearranged plan” shortly after it was acquired in an exchange.

Property acquired in an exchange and leased with option to buy is not held for use in business or for investment.

Your intention to eventually give away property you receive in an exchange will not defeat the exchange if the exchange is not a part of the gift transaction. In one case, the gift of a ranch received in an exchange was made to the taxpayer's children 9 months after the exchange. His general desire at the time of exchange was to eventually transfer it to his children and was not, in the court's view, inconsistent with his intent at that time to hold the ranch for productive use in business or for investment. He had no concrete plans to do so at the time of exchange.

Time Holding Considerations

We know both the Relinquished Property and the Replacement Property must be held for use in a trade or business or for investment. The big question that comes up more than any other is, “Yes, but for how long?” It’s a tough one to answer because the statute is silent on this issue. Therefore, it must be examined on individual facts and circumstances.

IRS has ruled that property transferred to a controlled corporation immediately following the exchange did not qualify. Rev. Rul. 75-293; Rev. Rul. 77-337

 However, a general intention to make a future transfer is probably OK. In one case, the taxpayer gifted the Replacement Property to his children nine months after the exchange. The court said the exchange was OK because even though the taxpayer contemplated eventually gifting the property to his children, he had no concrete plans to do so at the time of the exchange. Fred S. Wagensen, 74 TC 653.

Many time period holding problems created by taxpayers are linked to rental income property and the personal residence. How long must I operate the Replacement Property as a rental before I move in and occupy it as my primary residence? Again, it’s a matter of facts and circumstances. For example, at the time of the exchange, you have no intention of converting it to your primary residence. But an unforeseen event, not related to the exchange, takes place. Perhaps the death of a spouse. Or the rental turns out to be an unbearable negative cash flow situation. In such cases, you should have no problem supporting the like-kind exchange.

Here is a general rule-of-thumb I have used for many years with success. To be on the safe side, you should hold the Replacement Property for at least two years. In my opinion, this is the magic number. In a private letter ruling, the IRS told one taxpayer one year was not long enough to hold several rental houses being acquired as Replacement Property before they were sold. But the IRS did say two years would meet the intent of the statute and the properties could qualify if sold after the two-year holding period.

The two-year holding period pops up in many places. That’s the minimum holding period applying to the exchange with a relative rule. It’s the same for the installment sale rules between related parties. And it’s also the minimum time period a taxpayer must live in their primary residence to qualify for the §121 exclusion benefits on the sale of the residence.

If you have any doubts or questions about the classification of either your Relinquished Property or Replacement Property, be sure to discuss it with both your tax professional and your real estate agent.

Foreign Real Estate

The location of properties being exchanged is important. For purposes of the nonrecognition rules of §1031, real property located outside the United States does not qualify as like-kind property if exchanged for real property located in the United States. Property located in Guam, Puerto Rico, and U.S. possessions are treated as foreign real estate and do not qualify.

The Conference Committee Report stated no inference was intended to override or otherwise modify Section 932 involving the tax treatment of U.S. and Virgin Islands residents. Accordingly, real estate located in the U.S. Virgin Islands may qualify for §1031 treatment when traded for U.S. real estate.

Partnership Interests

Partnership interests are specifically excluded from like-kind exchange treatment. A partner's exchange of an interest in one partnership for another partner's interest in a different partnership cannot qualify for §1031 treatment. This rule does not apply to exchanges of interests in the same partnership.

A partnership as a business entity can qualify to exchange real estate it owns for other real estate.

Exchanges of Multiple Assets

The IRS issued AdvRevRul 89-121 to clarify an older ruling (Rev Rul 85-135) dealing with the transfer of multiple properties in a §1031 exchange. The advance ruling limits the application of §1031 provisions in an exchange of several assets of one business for a single asset of another.

Reg 1.1031(j)-1 explains rules dealing with exchanges of multiple assets.

Special Situations

In LTR 9851039, the Internal Revenue Service ruled the exchange of an agricultural conservation easement for a farm property qualifies as a tax-free exchange under Section 1031(a).

Figuring Boot and Recognized Gain

Receiving cash or other boot in a real estate exchange does not defeat the nontaxable provisions of §1031 for the like-kind property involved. If, in addition to the Replacement Property, you receive money or some other kind of boot, you may have taxable gain. But the good news is you are only taxed on gain that comes from the money and other boot received.