Section 1031 Like-Kind Exchanges
Introduction
Section 1031 of the Internal Revenue Code provides for nonrecognition treatment of the gain or loss arising from the exchange of property of a like kind. It has been in the Internal Revenue Code since 1924, and has remained substantially unchanged since that time. Section 1031 is available for all types of operating assets, and over the decades businesses have exchanged everything from railroad cars to restaurant equipment under Section 1031. One type of business property eligible for Section 1031, is real estate.
If you are considering structuring a real estate transaction as a like-kind exchange, the very first thing you should do, is analyze the income tax consequences of structuring the deal as a like-kind exchange, versus the income tax consequences of not structuring the deal as a like-kind exchange. Section 1031 does not eliminate the income tax on appreciated property; it merely defers the tax. Nonetheless, the ability to defer income tax on the appreciation in real estate under Section 1031 can be a powerful financial tool.
The Mechanics of Section 1031
Eligibility. Whether an interest in real estate is eligible for like-kind treatment depends upon the use of the real estate. Only two types of real estate qualify for nonrecognition treatment under Section 1031 : property used in a trade or business, and property held for investment. Both properties, the property given up and the property received, must either be used in a trade or business, or as an investment. Section 1031 does not apply to real estate which would be considered inventory or personal use property.
Section 1031 looks to the use of the asset at the time of exchange in order to determine it’s character for tax purposes. If at the time of the exchange the taxpayer uses the old property in a trade or business, or holds it for investment, and if, immediately after the exchange, the taxpayer uses the replacement property in a trade or business, or holds it for investment, both properties will be eligible for Section 1031. If, on the other hand, either property is personal use property or inventory in the hands of the taxpayer at the time of the exchange, the transaction is ineligible for Section 1031.
Although the rules governing the use of the properties are strict, the regulations permit a great deal of flexibility regarding the types of real estate which can be exchanged. Here are a few examples of the types of real estate interests which can be exchanged under Section 1031:
> raw land for a building;
> a house for an office building;
> farm land for urban real estate;
> several parcels for one parcel;
> one parcel for several parcels;
> investment property for property to be used in a trade or business;
> an interest as a joint tenant or tenant in common for an interest as a sole owner;
> any combination of the above examples.
As long as both properties, the property given up and the property received, are used in a trade or business, or held for investment, the properties will qualify for Section 1031.
Common Methods of Exchanges & the Safe Harbor Regulation
Direct Swaps. The simplest form of exchange is a direct swap, in which you simply deliver a deed to the old property in exchange for a deed to the replacement property.
Three-Cornered Exchanges. Often the sale of the old property can be characterized as a like-kind exchange, even though the seller of the new property does not want to swap if for the old property. For example, suppose you hold a parcel of appreciated raw land. You find a townhouse which is for sale for a fantastically low price, but you do not have funds sufficient to purchase it. The owner of the house wants cash and is not interested in owning your land. If you can locate a buyer who wants to pay cash for your land, the seller of the townhouse can swap the townhouse for your land, and sell the land to your buyer. This structure is known as a “three-cornered exchange”, or a “deferred like-kind exchange”.
Another type of three-cornered exchange is to have the buyer purchase the townhouse, and in turn swap it with you in exchange for the land. This can often all be done at one settlement table, and usually involves little more than having the taxpayer’s seller or buyer agreeing to serve as the middleman.
Use of an Escrow Agent in Three-Cornered Exchanges. If your seller is unwilling to cooperate in a like-kind exchange, if you are having timing problems, or if you are doing a multi-parcel exchange with multiple parties, you can use an escrow agent to structure a like-kind exchange.
Use of an Escrow Agent when You Have No Replacement Property. If you have not located replacement property at the time of settlement, you could convey the real estate to an escrow agent and have the escrow agent sell it for cash. If you can identify replacement property within forty-five days, the escrow agent can purchase the replacement property, and swap it with you for your old real estate.
Use of an Escrow Agent to Exchange Multiple Parcels. Suppose you have several parcels of appreciated real estate which you want to swap for one large parcel of real estate, but the owner of the large parcel wants cash. Or suppose you own a large parcel of appreciated real estate and wish to exchange if for several smaller parcels owned by different people. In both cases you can use an escrow agent to take title to your real estate, sell it for cash, purchase the new real estate, and swap it in exchange for the old real estate.
The solution is to swap the old property for the replacement property. After a year or two, you can refinance the new property by borrowing $2,000,000 against the property, and securing the loan with a mortgage. As a result, you will own the replacement property, and you will have $2,000,000 in cash, free of income tax.
The Safe Harbor Regulations. The regulations define several safe harbors, within which you can operate with confidence that the IRS will not challenge the transaction.
Sage Harbor No. 1: Mortgage or Letter of Credit. Under the first safe harbor, the taxpayer can have the buyer of the old property purchase the replacement property, and convey it to the taxpayer. The obligation of the purchaser of the old property to transfer the replacement property is permitted to be secured by a mortgage. It can also be secured by a stand-by letter of credit except upon failure of the purchaser to transfer like-kind replacement property.
Safe Harbor No 2: Cash Held in Escrow. Under the second safe harbor, the obligation of the buyer to transfer the replacement property is permitted to be secured by cash held in an escrow account.
Safe Harbor No. 3: A Qualified Intermediary. Under the third safe harbor, the seller can utilize a “qualified intermediary” to transact the deferred exchange. A “qualified intermediary” is a person who is not related to the taxpayer (a family member, attorney of the taxpayer, or a business associate), and who, for a fee if he wishes, acts to facilitate the exchange by entering into an agreement for the exchange of properties.
The agreement must state that the intermediary will acquire the old property, accept the proceeds, acquire the replacement property with the proceeds and transfer the replacement property to the seller.
Direct Deeds. Under the third safe harbor, and under Revenue Ruling 90-34, the IRS now permits direct deeds.
Interest or Growth Factor. The Seller can even specify that the seller is to receive the interest on the sales price until the replacement property is acquired. The seller can also specify a growth factor for the proceeds, which would require the buyer to purchase a higher-priced replacement property. If the seller receives the interest, the interest will be taxable to the seller, but it will not disqualify the transaction from like-kind treatment.
Reverse Exchanges. On September 15, 2000, the IRS issued Revenue Procedure 2000-37, which now provides a safe harbor for a reverse like-kind exchange. In a reverse like-kind exchange, the taxpayer acquires the replacement property before he disposes of his old property, usually by means of a bridge loan.
The safe harbor requires the execution of a Qualified Exchange Accommodation Agreement, by an Exchange Accommodation Titleholder. Rev. Proc. 2000-37 sets forth other requirements for the safe harbor as well. You can obtain a copy of Rev. Proc. 2000-37 at www.irs.gov
The Treatment of Cash & Mortgages
The Treatment of Boot. The receipt of boot (any non-like-kind property, which includes cash) by the taxpayer will not make the transaction ineligible for Section 1031 treatment.
However, any boot received by the taxpayer will be taxable to the extent of the gain the taxpayer has realized. You can swap your real estate partly for real estate and partly for cash. However, you will have to recognize gain on the exchange to the extent of the cash that you receive.
The Treatment of Mortgages. Under the Internal Revenue Code, relief of indebtedness is considered income. Under Section 1031, if you swap property with a mortgage in exchange for property which is mortgage-free, the principal amount of the mortgage on the old property will be considered income to you. However, Section 1031 has special rules which permit the netting of mortgages. If you trade mortgaged property in exchange for new mortgage equals or exceeds the principal amount of your old mortgage, and you will not have to recognize income on the exchange.
Use of Mortgages to Avoid Recognition of Gain. The Tax Court has approved the liberal use of mortgages to facilitate like-kind exchanges. The ability to utilize mortgages provides great flexibility in structuring like-kind exchanges, even enabling the taxpayer to pull cash out of the real estate tax-free.
Time Limits & Basis Adjustments
Time Restrictions Upon Like-Kind Exchanges. The settlement date on the old property is the trigger date for two time restrictions upon a like-kind exchange. The new property must be identified within 45 days after the settlement date for the transfer of the old property. In addition, settlement on the new property must occur within 180 days after settlement on the old property.
Basis Adjustments under Section 1031. Section 1031 does not eliminate the income tax on the appreciation of real estate. It is simply a method to defer the tax, even though the taxpayer is changing the form of this investment. Section 1031 defers the tax by requiring the owner to transfer to the new property the same basis he had in the old property. In tax parlance, this is known as a carryover basis. This carryover basis is increased by any cash which the taxpayer contributes to the purchase of the new property.
Summary
If you are selling appreciated investment or business real estate, and you plan to use the proceeds to purchase new real estate, you may wish to structure the transaction as a like-kind exchange under Section 1031. Section 1031 will allow you to defer the tax on the appreciation of the old real estate. The regulations allow a great deal of flexibility in structuring like-kind exchanges, so that Section 1031 deferral is available in a variety of circumstances.
