Section 1031 "Like Kind" Exchanges

Our corporate, real estate and tax attorneys are available to assist clients in the acquisition and sale of property and the issues and complexities involved in such transactions, including structuring and tax considerations.  Our attorneys have the experience and sophistication in dealing with issues involved in conventional acquisitions and sales as well as complex transactions involving new construction, sale-leasebacks, like-kind exchanges and the acquisition and sale of foreclosed properties. 

A “1031 exchange” (also called a Tax-Deferred Exchange) is a powerful tax deferral strategy for taxpayers.   Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.  Essentially, a 1031 exchange is a method where a property owner trades one or more relinquished properties for one or more replacement properties, while deferring payment of federal and some state taxes.

The theory behind 1031 exchanges is that since the individual is “exchanging” properties, as opposed to selling one and purchasing another, no gain is actually being realized.  It is important to note that the government does not consider the transaction a “tax free” transaction because the taxpayer’s basis in the acquired property remains the same as it was in the original property.  Since the basis remains the same, when the taxpayer sells the acquired property his gain will include any gain from the original property plus any gain from the acquired property. 

Basic Rules for a qualifying a 1031 Exchange

First, and most importantly, the property must be property which is held for trade, business or investment purposes.  While these categories clearly include real estate, it does not include a taxpayer’s personal residence. 

It is also essential that the acquired property be taken in the same name(s) as the original property.  For example, if a husband and wife own investment property in joint tenancy, the acquired property must also be taken in joint tenancy. 

Furthermore, the acquired property must be a “like-kind” replacement of the original property.  This means that any sort investment or business property must be exchanged for investment or business property.  Investment property can be exchanged for business property and vice versa, but neither can be exchanged for a taxpayer’s personal residence. 

Also, a taxpayer can take his 100% share in real property and exchange it for a 50% interest in another piece of real property that is held by multiple investors. 

Finally, it is important to consider the impact of other property that is mixed in with the deal.  This “other property” can sometimes take the form of cash and is commonly referred to as “boot.”  Boot received is the money or the fair market value of the other property received in the exchange and it is taxable.  Other property includes all property that does not fall within the umbrella of “like-kind”, such as personal property, cash or cash equivalents.  A surefire method of avoiding boot is to always acquire property that is equal or greater in value, as trading down will always result in some form of boot received.

Basic types of § 1031 Exchanges

The most basic and simple form of a § 1031 exchange is the simultaneous or back to back exchange in which there no interval of time between the closing to the acquired property and the closing to the original property. 

A second method, commonly referred to by its seminal Supreme Court case, called a “Starker Exchange” is also commonly employed.   The Starker Exchange involves a scenario where the acquired property is closed on at a later point in time than the original property.  There are strict time frames established by the Internal Revenue Code and its Regulations for the successful completion of a Starker Exchange. 

A third common method is the “reverse exchange” in which the acquired property is purchased and closed on before the original property is sold.  Usually, in this situation a disinterested third party will hold the acquired property until the taxpayer finds a purchaser for the original property.  Once the taxpayer finds a purchaser and closes on the original property, the closing on the acquired property would take place. 

Finally, another common used method is the “Improvement Exchange” in which a taxpayer desires to acquire property and arrange for improvements to be made on the property before it is received as replacement property.  A common example occurs when a taxpayer buys an unimproved lot and then constructs a building.  The purchaser would have a third party acquire title to the property, hold title to the property until the improvements are complete and then convey title to the taxpayer as his acquired property.  The IRS has issued either Regulations or Safe Harbor Guidance on all of these topics. 

§ 1031 transactions are complicated transactions that require a detailed knowledge of the Internal Revenue Code and its Regulations.  If not done properly, the IRS may force the taxpayer to realize the gain from the transaction which can have serious negative tax consequences.  If you are considering a transaction involving a § 1031 exchange we encourage you to contact our attorneys.

For more information concerning § 1031 exchanges and/or our Corporate and/or Real Estate Departments, please contact:

Brian T. O’Connor       (203) 358-0800        BOConnor@dmoc.com
Charles J. Spiess        (203) 358-0800        CSpiess@dmoc.com
Robert E. Murray        (203) 358-0800        RMurray@dmoc.com
              
This publication is a service to our clients and friends.  It is designed only to give general information on the development actually covered.  It is not intended to be a comprehensive summary of recent developments in the law, treat exhaustively the subjects covered, provide legal advice or render a legal opinion.

IRS Circular 230 Disclosure: Any U.S. tax advice contained in this communication was not written to be used for and cannot be used for (i) purposes of avoiding any tax related penalties that may be imposed under federal tax laws, or (ii) the promotion, marketing or recommending to another party of any transaction or matter.