irc section 1031 tax-deferred exchanges tax-deferred exchanges irc section 1031 section 1031 has...

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IRC Section 1031

Tax-Deferred Exchanges

IRC Section 1031

Section 1031 has been part of the Internal Revenue Code since 1921.

The language of the Code has been modified very little since 1921, but significant regulatory guidance has made these transactions accessible to all taxpayers.

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Starker and The 1984 Tax Reform Act

In the mid-1970s, the Starker cases set the stage for the non-simultaneous exchange.

In 1984, the Tax Reform Act formally sanctioned the delay between the disposition of relinquished property and the acquisition of replacement property.

The 1984 Tax Reform Act also imposed the 45-day Identification Period and the 180-day Exchange Period.

Three General Statutory Requirements

Properties Must be Held for Business or Investment Use

Properties Must Be Like-Kind to Each Other

The Transaction Must be Structured as an Exchange of One Property for Another

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Property Held for Investment or Business Use

Property must be held for investment or for use in a trade or business in which Taxpayer is engaged.

How long must the Taxpayer own the property prior to the exchange?

Intent is key to this inquiry.

Look at facts and circumstances.

Consider individual risk tolerance.

Consider Taxpayer’s behavior.

Property Held for Investment or Business Use Taxpayer sells relinquished property in August 2015and structures a tax-deferred exchange.

Taxpayer acquires replacement property in November 2015.

In January 2016, Taxpayer receives, and accepts, an offer to sell his newly acquired replacement property to the owner of adjacent property.

Can Taxpayer structure the sale as an exchange?

Has Taxpayer held the replacement property for investment?

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Property Held for Investment or Business Use PLR 8429039 – two years of business or investment use is sufficient to meet the requirement under IRC Section 1031 that the property was held for the requisite intent.

Neal T. Baker Enterprises, Inc. v. Commissioner (1998) – Taxpayer attempts to exchange vacant land after owning it for 11 years. Taxpayer is deemed to have held the land “for sale” during the entire holding period.

Like-Kind Standard

Property classified as realty under state law is “like-kind”.

“Like-Kind” refers to the nature or the character of the property, not its grade or quality.

Unimproved property is like-kind to improved property.

The property need not be income producing.

Personal property must be exchanged for property that is of a like class.

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The Exchange Requirement

The Exchange must be structured as a reciprocal transfer of one property for another as distinguished from a sale followed by a re-investment.

Taxpayer may not actually or constructively receive the proceeds of sale.

The Exchange Requirement

Crandall & Dulin v. Commissioner T.C. Summary Opinion, February 2011 – Taxpayers failed to include any exchange language in their documents and had constructive receipt of their sale proceeds.

Peter T. Morton v. United States of America - April 2011 – Taxpayer exchanged a G-IV aircraft for a G-V. Contrary to Taxpayer’s instruction the closing company wired sale proceeds to Taxpayer’s account. The error was quickly rectified, and Taxpayer successfully argued that his intention was very clearly documented and he should not be penalized for the error of the closer.

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Forward Exchange Mechanics

Prior to Closing on the Sale of Relinquished Property:

Taxpayer executes a series of documents evidencing their intent to exchange the property.

At closing, net sale proceeds are wired into the qualified trust account.

Forward Exchange Mechanics

STEP 1: Sale of Relinquished Property

Taxpayer

QI

Assignment of Contract Notice to Purchaser

Relinquished Property Proceeds

Purchaser

Title to Relinquished Property

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Forward Exchange Mechanics

What makes the account a “qualified” account?

Taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash held in the account must be limited to those specific exceptions described in Treasury Reg. 1.1031(k)-1(g)(6).

Forward Exchange Mechanics

The Qualified Intermediary “Acquires and Transfers” both properties in the exchange.

TAM 200130001 – failure to comply with the specific provisions of the safe harbor requirement that the QI “acquires and transfers” the property results in the disqualification of an exchange.

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Forward Exchange Mechanics

STEP 2: Identification of Replacement Property

Taxpayer

QI

The Identification Notice must be made in a written document that is signed by the Taxpayer and hand delivered, mailed, telecopied or otherwise sent before the end of the Identification Period.

Identification Options The Taxpayer can choose any one of the three rules when identifying replacement property:

Three-Property Rule - Three properties of any fair market value;

200% Rule - Any number of properties as long as their aggregate FMV as of the end of the Identification Period does not exceed 200% of the aggregate FMV of all relinquished properties;

95% Rule - If the Taxpayer fails to comply with the three-property and 200% identification rules, its identification will be considered valid and any replacement property which is identified within 45 days and received within 180 days will qualify; provided the Taxpayer receives at least 95% of the value of all of the identified properties before the end of the Exchange Period.

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Taxpayer sells relinquished property for $5 million and identifies the following properties:

1. 135 S. LaSalle Street, Chicago

2. The Chrysler Building

3. NW corner of Main and 12th, Walnut Creek, CA

Identification Issues

1. 135 S. LaSalle Street, Chicago, IL

Property may be described by Street Address, City & State

2. The Chrysler Building

Property may be described by “distinguishable name”

3. NW corner of Main & 12th, Walnut Creek, CA

Property must be “unambiguously described”.

Identification Issues

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1. 135 S. LaSalle Street, Chicago, IL

Property may be described by Street Address, City & State

If Taxpayer sells Relinquished Property for $5 million, is it Taxpayer’s intention to acquire 100% of the building located at 135 S. LaSalle Street, Chicago, IL.

If Taxpayer intends to acquire a tenancy-in-common interest in the Replacement Property is it sufficient to identify the entire property?

Identification Issues

Taxpayer sells relinquished property on February, 2012.

Taxpayer’s 45th day falls on a Saturday, March 17, 2012.

On Monday, March 19, Taxpayer sends an Identification form to its QI with the date of March 17.

The QI acknowledges receipt of the Identification form as of March 19, but Taxpayer changes the date to March 17.

Dobrich v. Commissioner, T.C. Memo 1997-477

The Tax Court found clear and convincing evidence of Taxpayer’s intent to defraud the government by submitting false documents in order to evade taxes believed to be owing.

Identification Issues

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Forward Exchange Mechanics

STEP 3: Acquisition of Replacement Property

Taxpayer Assignment of Contract Notice to Seller

QI

Seller

Replacement Property is deeded directly from the Seller to the Taxpayer

Cash held by the QI is paid directly to the Seller or into a closing escrow.

Boot Netting Rules What is “Boot”?

Boot is other property or money received in an exchange that is not like kind to the property given up.

The term originated (purportedly) in the days of horse trading – take the horse and get the boots too.

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Boot Netting Rules How to Recognize and Avoid Boot

The rules regarding the effect of receiving boot are found in the Treasury Regulations at 1.1031(b)-1.

The gain, if any, shall not exceed the fair market value of the money or other property received.

The loss, if any, shall not be recognized under Section 1031 to any extent.

Boot Netting Rules

General Rules to Avoid Boot

Trade even or up in value;

AND

Reinvest all of your equity into replacement property.

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Boot Netting Rules

General Rules to Avoid Boot

Cash paid to acquire replacement property offsets cash received on the sale of relinquished property:

Relinquished Property

FMV: $100 Debt: $ 0 Equity: $100

Replacement Property

FMV: $100 Debt: $ 0 Equity: $100

No boot received.

Boot Netting Rules

General Rules to Avoid Boot

Cash paid to acquire replacement property offsets debt relief on the sale of relinquished property:

Relinquished Property

FMV: $100 Debt: $ 50 Equity: $ 50

Replacement Property

FMV: $100 Debt: $ 0 Equity: $100

Taxpayer is relieved of $50 of debt. That debt relief is considered consideration that is “other property or money” that can cause gain recognition.

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