1031 Exchange Blog

1031 EXCHANGE GENERAL

Does Little to No Gain on an Investment Property Mean No Need for a 1031 Exchange?

03/30/22

Deciding whether or not to do a 1031 Exchange when large gains are involved is a simple answer, YES! But, a 1031 ...

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Many investors know that they can shelter the capital gains on the sale of investment properties when they structure the sale as part of a Section 1031 like-kind exchange. However, they are typically unsure about the consequences of a transaction involving the sale of an investment property with little or no gain.

<h2>The Situation</h2>

Mike owns an investment property that he bought as part of a 1031 exchange at the height of the real estate market in 2006 for approximately $296,000. With the decline in the real estate market over the next few years, the property was worth only about $209,000 in 2012. Mike received an offer for $305,000 in 2020, and is not sure whether a 1031 exchange is the right course of action.

<h2>The Problem</h2>

Mike’s initial thoughts regarding the current house are that he paid $296,000 for the house and the current offer is $305,000. His analysis is:

Purchase                      $296,000

Sale                              $305,000

Gain                             $9,000

20% Fed Cap Gains        $1,800

5% State Cap Gains       $450

Total Tax Burden           $2,250

However, Mike has forgotten a couple of critical facts. First, he acquired this property in 2006 as part of a 1031 exchange, in which he sheltered a substantial gain. Second, he neglected to account for the depreciation recapture on both transactions. The real math for Mike’s current exchange is:

Purchase #1                  $223,000

Sale #1                         $295,000          (5-year hold)

Gain #1                         $72,000

20% Fed Cap Gains        $14,400*

5% State Cap Gains       $3,600*

5 Years Depreciation     $40,505

Fed Recapture (25%)     $10,126*

State Recapture (5%)     $2,025*

Purchase #2                  $296,000

Sale #2                         $305,000          (14-year hold)

Gain #2                         $9,000

20% Fed Cap Gains        $1,800

5% State Cap Gains       $450*

14 Years Depreciation   $150,690

Fed Recapture (25%)     $37,673*

State Recapture (5%)     $7,535*

TAXES OWED WITHOUT EXCHANGE

Property 1

20% Fed Cap Gains        $14,400*

5% State Cap Gains       $3,600*

Fed Recapture (25%)     $10,126*

State Recapture (5%)     $2,025*

Property 2

20% Fed Cap Gains        $1,800

5% State Cap Gains       $450*

Fed Recapture (25%)     $37,673*

State Recapture (5%)     $7,535*

TOTAL TAXES DUE         $77,609

When Mike overlooked the previous 1031 exchange, he neglected to account for the deferred taxes from that transaction. He also overlooked the significant depreciation he had taken during the time he owned this current property. While the gain on this current property is nominal, the potential tax liability in an outright sale would be substantial due to the need to recognize previously deferred taxes as well as the depreciation recapture.

<h2>The Solution: 1031 Exchange</h2>

Mike will sell this property as part of another 1031 exchange. After consulting with his attorney and a Qualified Intermediary (QI) like Accruit, Mike now understands that a  1031 Exchange is a tax deferral strategy, and that he would need to recognize those previously deferred taxes upon a sale. Mike visited the <a aria-label="Capital Gains Calculator" href="/capital-gains-calculator" title="Capital Gains Calculator">Capital Gains Calculato</a>r on the Accruit website to get a better understanding of the tax ramifications of a sale without another 1031 exchange.

Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Mike’s QI to be held on his behalf until the purchase of his replacement property. This is necessary because a person doing an exchange cannot come in actual or constructive receipt of the net sale proceeds while the exchange is pending.

Within 45 days after the closing on the sale, Mike identified suitable replacement property (learn more about <a aria-label="1031 Exchange Rules and Regulations" href="/blog/what-are-rules-identification-and-receipt-replacement-property-irc-%C2%A71031-tax-deferred-exchange" title="1031 Exchange Rules and Regulations">Identification rules in 1031 exchanges</a>). Mike completed the acquisition of that property approximately sixty days later, well within 180 days of the sale of his relinquished property, utilizing the exchange proceeds held by his QI. Mike has now relocated his investment to a more investor friendly town.

<h2>The Result</h2>

Mike has successfully completed a 1031 exchange from a single-family home in a town that imposes heavy regulatory burdens on landlords to a neighboring town that is more investor friendly. He exchanged equal or up in value, using all of his equity, and thereby fully deferred the capital gain and depreciation recapture taxes on this property, as well as from his previous investment property.

Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.

As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property.

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Title:

Does Little to No Gain on an Investment Property Mean No Need for a 1031 Exchange?

03/30/22

Deciding whether or not to do a 1031 Exchange when large gains are involved is a simple answer, YES! But, a 1031 ...

1031 Tax Deferred Exchanges Between Related Parties

03/28/22

The Related Party rules amend section 1031 of the tax code to prevent taxpayers from using a related party to abuse ...

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Historically, real estate transactions were not uncommon amongst family and other related parties. Given this and prior history of taxpayers utilizing family or related parties to manipulate the existing IRS regulations on 1031 exchanges, Congress amended the code section to include Related Party rules in relation to 1031 exchanges. Due to today's booming real estate market, it is even more popular for family to try to help the younger generation start their real estate investment journey, which makes it more important than ever to understand the Related Party rules outlined below.

<h2>Background to the Related Party rules</h2>

Tax deferral under <a href="/exchange-library/internal-revenue-code-section-1031">section 1031 of the U.S. tax code</a> is very taxpayer-friendly, potentially allowing taxpayers to defer capital gain, depreciation recapture, healthcare tax, and state tax.   However, to take advantage of this code section, taxpayers have to play fair and strictly follow the rules.  In the past, it was possible to manipulate the rules to achieve a favorable outcome by bringing a party related to the taxpayer into the transaction. In 1989, Congress amended the code section to stop this abuse. The amendment prohibits taxpayers from entering into transactions with related parties, subject to a few limited exceptions. According to the legislative history of §1031(f) “if a related party exchange is followed shortly by a disposition of the property, the related parties, have in effect, cashed out of the investment.”

This new section, 1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—

(i) the related person disposes of such property, or

(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”

<h2>What was the abuse that gave rise to the Related Party rules?</h2>

Take as an example “Parent Company” which has Property A for sale with a lot of built-in gain and no need to acquire a replacement property.  Its affiliate, “Subsidiary Company” owns Property B of similar value with a high basis. In any exchange, the basis is carried over from the relinquished property to the replacement property.  So rather than sell the properties outright, the two companies enter into an exchange with one another to defer taxes.  Parent Company holds Property B indefinitely, but shortly after the exchange, Subsidiary Company sells Property A.  Since Subsidiary Company has a high basis in Property A, there is little tax effect to it upon the sale.  This was a common occurrence prior to the 1989 Related Party rules addition to section 1031.

<h2>Can any part of a taxpayer’s exchange transaction involve a related party?</h2>

Often a taxpayer will sell the relinquished property to a related party while acquiring replacement property from an unrelated party.  This structure is not prohibited by the Related Party rules since it does not involve the taxpayer carrying over tax basis into the property sold (it is carried over into the property being purchased), and therefore there is no opportunity for the tax abuse that the rules seek to curb.  Between 2007 and 2010 there were a series of <a href="http://www.irs.gov/pub/irs-wd/0709036.pdf" target="_blank">IRS Private Letter Rulings</a> confirming this position.

However, when a taxpayer sells relinquished property to a third party and acquires replacement property from a related party, the tax abuse opportunity is present, despite the fact that the related parties are not exchanging with one another. By purchasing property from a related party, the taxpayer can potentially dispose of low basis property without recognizing the gain.

<h2>What relationships constitute related parties?</h2>

Rather than reinventing the wheel, the drafters of the Related Party rules chose to refer to existing code sections which already defined “related persons” for other purposes.  Section 1031(f) states that “For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267 (b) or 707 (b)(1).”  Those relationships in these code sections include

<ul>
<li>Members of the same family unit (siblings, spouse, ancestors, and lineal descendants);</li>
<li>Corporation where more than 50% of the value of the stock is owned directly or indirectly by or for one particular individual;</li>
<li>Two (2) corporations that are in the same controlled group (as defined in subsection (f);</li>
<li>A grantor and a fiduciary of any trust;</li>
<li>A fiduciary of one trust and the fiduciary and/or beneficiary of another trust where the same person is the grantor for both trusts;</li>
<li>A fiduciary of a trust and a beneficiary of the same trust;</li>
<li>Corporation where more than 50% of the value of the stock is owned directly or indirectly by or for one particular trust or by or for the grantor or fiduciary of the trust;</li>
<li>An organization qualified under Section 501 of the Internal Revenue Code (relating to certain educational or charitable non-profit organizations) which is controlled directly or indirectly by a specific person or (if such person is an individual) by members of the family of such individual;</li>
<li>A corporation and a partnership if the same person or persons own: more than 50% in value of the outstanding stock of the corporation, and more than 50% of the capital interest, or the profits interest, in the partnership;</li>
<li>An S corporation and another S corporation or a C corporation if the same person or persons own more than 50% in value of the outstanding stock of each corporation;</li>
<li>A partnership and a person owning, directly or indirectly, more than a 50% capital interest or a 50% profits interest, in such partnership;</li>
<li>Two partnerships in which the same person or persons own, directly or indirectly, more than a 50% capital interest or a 50% profits interest, in both partnerships;</li>
<li>An executor of an estate and the beneficiaries of the estate.</li>
</ul>

There are sometimes opportunities for transactions that may involve relatives, although not defined as related parties.  Exchanges with aunts, uncles, nieces, nephews, in-laws may fall into that category.  Additionally, oftentimes parties hold 50% interests in partnerships, LLCs or company stock, as opposed to more than 50%.

<h2>Summary</h2>

The underlying rational for a tax deferred exchange is the continuity of investment without a cashing out.  Prior to the Related Party rules, the taxpayer could use a related party to effectively cash out of an investment, while technically abiding by the requirements of a deferred exchange. Next, we examine <a href="/blog/1031-exchange-related-party-rules-exceptions-and-misconceptions">exceptions to and misconceptions of the Related Party rules for 1031 exchanges</a>.

Updated 3/28/2022.

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1031 Tax Deferred Exchanges Between Related Parties

03/28/22

The Related Party rules amend section 1031 of the tax code to prevent taxpayers from using a related party to abuse ...

1031 Exchanges for Condominium Deconversions

03/24/22

Condominium decoversions are increasingly popular in urban areas, such as Chicago, due to the increasing need for rental properties. Special ...

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Condominium deconversions have been taking place quite frequently in the greater Chicagoland area and elsewhere.  For reasons including the ones set forth below, a condominium deconversion takes place when 75% (or in some jurisdictions a higher percentage) of the owners choose to sell the building to someone interested in converting it to use as an apartment building.  A deconversion can be precipitated by one or more factors.  Rental properties may be in short supply in the area and converting the building to apartments may be far more valuable than the aggregate value of the individual condo units.  Also, as the building gets older and requires more regular fix ups, unit owners are reluctant to continuously pay for special assessments that might otherwise keep the property in proper condition.  Furthermore, the need for ongoing special assessments may make it difficult to sell the unit or at the very least have a negative impact on the price.

<h2>Requirements for a 1031 Exchange</h2>

Like any other sale of real estate, those who utilized their unit as an investment or business use property and are seeking to use a tax deferred exchange have to adhere to the specific governing regulations.  One such requirement is that the exchange company, known as a Qualified Intermediary (QI), has to take tax ownership of the property from the property owner and to transfer that ownership to the buyer. Click to learn more about <a aria-label="Qualified Intermediary services" href="/qi-services" title="Qualified Intermediary Services">QI services</a>. This can be accomplished by the taxpayer deeding the property to the QI and the QI deeding to the buyer.  Another permitted way to accomplish this is for the QI to be a party to the sale agreement, meaning that the QI has a legal obligation to cause legal title to be conveyed to the buyer.  These two options are somewhat cumbersome. In order to make that process as simple as possible, the Treasury Department provided a shortcut in the regulations to accomplish tax ownership of the relinquished property passing through the QI.

(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that  agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.

In short, sellers’ “rights” in and to the sale agreement have to be assigned to the QI and all parties to the agreement have to receive written notice of this assignment. However, meeting this requirement in a sale of an individual owner’s unit presents a practical problem since typically when it comes to condominiums the sale agreement is signed only by the condominium association, and not by the actual unit owner.

<h2>Meeting 1031 Exchange Rules on a Conversion Property</h2>

In this blog writer’s shop, we attempt to bridge this gap by having slightly different language on this Assignment of Relinquished Property when it involves a sale due to conversion.  The italicized part of the assignment document appears below:

Assignment.  The undersigned (“Exchanger”) hereby assigns to Accruit, LLC (“Accruit”) all of Exchanger's rights (but not Exchanger’s liabilities or obligations), referred to hereafter as the “Assignment”, under that certain Purchase and Sale Agreement (the “Relinquished Property Contract”) between the ____________ Condominium Association as Seller, of which ___________ is a condominium unit owner as to her percentage ownership in the comment elements in the ______________ Condominium Association pursuant to 765 ILCS 605/15 of the Illinois Condominium Property Act, the unit owner being the Exchanger and Relinquished Property Buyer being the buyer (identified above).  If not previously provided, simultaneously with the execution of this Assignment by the parties, Exchanger shall promptly provide Accruit with a copy of the Relinquished Property Contract.

The challenge is assigning the rights to the unit owner’s sale of the unit in a situation where the unit owner is not a direct signer nor party of the agreement.  Instead, the taxpayer is assigning the rights in his or her derivative capacity as an owner in the property being sold to the party seeking to change the property into an apartment building. Notice of the assignment is also given to the parties to the contract, usually by tendering it to their lawyers as the agent for the parties.

Sales of condominium buildings are happening regularly, and many unit owners are seeking to receive tax deferral by utilizing a 1031 exchange opportunity.  The manner in which the sale contract is signed presents a slight challenge to meet the requirements set forth in the 1031 exchange rules.  However, the spirit of those rules can be followed with an assignment of rights whereby the language in the assignment is changed slightly to account for the lack of a unit owner’s being a direct party to the sale agreement.

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Title:

1031 Exchanges for Condominium Deconversions

03/24/22

Condominium decoversions are increasingly popular in urban areas, such as Chicago, due to the increasing need for rental properties. Special ...

Cash Out Refinance Before or After a 1031 Exchange?

capital gains tax

03/21/22

Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg ...

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Most taxpayers wish to defer tax in full when completing a <a href="/services/1031-exchange">1031 exchange</a>.  In order to accomplish this, one simple rule of thumb is that the taxpayer must trade “up or equal” in value.  Perhaps a better way to look at this is to make sure the net proceeds of sale (i.e. the amount held in the exchange account) are used in full and the taxpayer puts on equal or greater debt on the new property compared to the amount paid off at the time of closing on the sale.  Another expression sometimes used is that the taxpayer should have “no net debt relief.”  Any cash taken out at closing and any debt that is not covered could be subject to:

<ul>
<li>Capital gains tax</li>
<li>Recapture of depreciation</li>
<li>State taxes</li>
<li>Net Investment Income Tax (also known as Affordable Care Act tax)</li>
</ul>

Oftentimes with exchange transactions, taxpayers wish to receive some cash out for various reasons.  Any cash generated at the time of the sale that is not reinvested is referred to as “boot” and the amount is taxable.  There are a couple of possible ways to gain access to that cash while still receiving full tax deferral.

<h2>Refinancing Relinquished Property Prior to Closing</h2>

For an owner of real estate, not engaging in a 1031 exchange, who wishes to refinance it at any time, any cash proceeds received are not subject to tax. However, in many cases, a taxpayer looking ahead to an upcoming exchange of his property may find himself with a high amount of equity and relatively low (or no) debt, this will require him to reinvest all the cash (and match debt).  The taxpayer may wish to finance or refinance the property pulling cash out and later go to closing with higher debt and lower cash equity, as a result his reinvestment requirements for the replacement exchange property are suddenly very different.  Essentially he walks away from the transaction with the debt on the property paid off, cash in his pocket, higher debt and lower equity in his replacement property and total tax referral The problem with this approach is that the IRS does not like it.  It is almost like cheating.  Essentially it is substituting new debt for cash taken out.  Since the taxpayer cannot take out cash on a tax deferred basis at closing, essentially doing the same thing just prior to the closing should be disallowed as well. The IRS does not look favorably upon a step transaction, which basically means that if something is not allowed to be done in a direct fashion (taking out cash at closing), by taking a few additional steps to avoid the application of the rule, is not allowed either.

There are a couple of facts which may improve the IRS position on these refinance transactions.  One of these is the impression that the refinance is not done in anticipation of the exchange of the property.  In general, the more time that elapses between any cash out refinance and the eventual sale of the property is in the taxpayer’s best interest  There is no bright line safe harbor for this, but at the very least if it is done somewhat prior to listing the property, that fact would be helpful.  The other consideration that comes up a lot in IRS cases is the presence of independent business reasons for the refinance.  Maybe the taxpayer’s business is having cash flow problems.  Maybe the property needs a new roof, etc.  To the extent that the refinance is done for other reasons and not solely to effect a favorable change to the debt and equity numbers, a taxpayer should be able to refinance even while contemplating a subsequent 1031 exchange of the property.

<h2>Refinancing Replacement Property After Closing</h2>

As was stated above, in the absence of any exchange transaction, a taxpayer who chooses to do a cash out refinance does not trigger any tax.  The question then is whether that principle applies to refinancing to pull equity out after the acquisition of the replacement property is complete.  Is that taxpayer in any different position from one who is doing a cash out refinance for property held but not part of an exchange transaction?  Probably not and accordingly, the IRS does not seem to disallow these post-exchange refinancings.  The American Bar Association Section on Taxation addressed these issues, and others, as part of an open report it prepared after the exchange rules came out.  The committee concluded that in the case of pre-exchange refinance the taxpayer is no longer obligated to pay the debt once the loan is paid off at the closing, while still retaining the cash.  In a post-exchange transaction, the taxpayer retains the cash but has an outstanding obligation to repay the debt.  The committee concluded:

<blockquote>
“The key to the distinction between pre-and post-exchange refinancings is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for pre-exchange relinquished property refinancing upon transfer of the relinquished property.  A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth.”
</blockquote>

Consistent with this reasoning, one noted author used the term “nanosecond” to indicate how long a taxpayer needs to wait before entering into a cash out refinance on the replacement property.  In other words, once a taxpayer owns the replacement property and refinances it incurring a repayment obligation, that taxpayer is in no different position than anyone else owning property and refinancing it.  Most authors take a similar position, but caution not to have the cash out refinance done concurrently with the acquisition of the property nor to have it prearranged prior to the purchase of the property.  Best practice would be to start the cash out refinance process any time after the replacement property acquisition.

<h2>Summary of Cash Out Refinance in 1031 Exchange</h2>

Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg of an exchange.  Any sums paid to the taxpayer at closing are subject to taxation.  As an alternative, a taxpayer may wish to refinance the relinquished property before the exchange or refinance the replacement property after the exchange.  In the absence of mitigating factors, refinancing the relinquished property is generally discouraged, however  refinancing the replacement property should not result in any tax issues and should not jeopardize the tax deferral on the transaction.  The primary logic for these positions is that with the former, the taxpayer is able to pay off the loan debt at the closing, whereas in the second alternative the taxpayer retains the debt obligation as an offset to the receipt of cash.

<a href="https://cta-redirect.hubspot.com/cta/redirect/6205670/54985636-c73e-4c3… alt="Forward Exchanges Download" class="hs-cta-img" height="150" id="hs-cta-img-54985636-c73e-4c3d-9d46-a49349f9bf90" src="https://no-cache.hubspot.com/cta/default/6205670/54985636-c73e-4c3d-9d4…; style="border-width:0px;" width="1320" /></a><script charset="utf-8" src="https://js.hscta.net/cta/current.js"></script><script type="text/javascript"> hbspt.cta.load(6205670, '54985636-c73e-4c3d-9d46-a49349f9bf90', {}); </script>

Updated 3/21/2022.

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Title:

Cash Out Refinance Before or After a 1031 Exchange?

capital gains tax

03/21/22

Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg ...

1031 Exchanges: Unique Examples of Real Property

03/17/22

Despite leaving real estate as the only asset class, sometimes it is not immediately clear if a type of asset ...

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Over the years we have written many posts on a variety of technical aspects of IRC Section 1031 Like-Kind Exchanges. We have written about 1031 Exchange <a href="/blog/1031-tips-deferred-like-kind-exchange-deadlines-%E2%80%93-basics">basics</a>; <a href="/blog/are-1031-reverse-tax-deferred-exchanges-real-estate-approved-irs">reverse</a> and <a href="/blog/can-property-improvement-costs-be-part-1031-tax-deferred-exchange">build-to-suit/improvement</a> exchanges; and about various <a href="/blog/complex-issues-concerning-section-1031-tax-deferred-exchanges">complex</a> issues in 1031 exchanges. In recent years, new regulations regarding the definition of real estate were evoked, and we covered those in another recent post.

We must remember, that Congress limited the application of Section 1031 to real property, by eliminating personal property, with the passage of the Tax Cuts and Jobs Act of 2017 (TCJA). Effective as of January 1, 2018, only transactions involving interests in real property qualify for 1031 exchange treatment.

Recently, we have encountered some rare situations involving unique investment opportunities. Despite leaving real estate as the only asset class, sometimes it is not immediately clear if a type of asset owned is like-kind to conventional real estate ownership. While the majority of 1031 exchanges involve the exchange of one building for another building, or one tract of farmland for another tract of farmland, the term “like-kind” does not mean that the properties being exchanged must be identical in form. Here are some examples of recent transactions involving some less common real property being exchanged. Note that all of these examples were properly structured as 1031 exchanges.

<h2>Less Commonly Known Real Property Examples</h2>

Boat Slip 
Mary sold a multi-family rental property but did not want to reinvest in a similar property. She was considering various replacement property strategies and ultimately acquired a boat slip. Her plan is to treat the boat slip much like an Airbnb or VRBO for short-term rentals. The boat slip she acquired is in Florida, where such properties are transferred by a deeded interest in the property.

Mobile Home 
Nicholas sold a rental condominium, and wanted to get away from the rigors of complying with condo association rules. He identified and acquired a double-wide trailer in a mobile home community. Nicholas will be using this mobile home as a rental property. Mobile homes are typically towed into place on their own axles and are initially registered and licensed as motor vehicles. Nicholas’ mobile home was acquired in Florida, where the law allows the mobile home to be affixed to a foundation and utilities, and for the mobile home to then be treated as real property under state law. This “de-titling” process affords similar treatment for mobile homes and manufactured homes in many other states.

Floating Home 
Tom sold a small mixed-use property near the beach. He likes that the property is near the water, but the mixed-use nature of the property often resulted in conflicts between the residential tenants and the commercial tenants. Tom found a floating home for sale in a nearby community and wondered whether that would qualify as real property for 1031 exchange purposes. This floating home is moored in a harbor, and loosely attached to water, sewer, and electric lines provided by the harbor. Fortunately for Tom, California, and a couple of other states, classify these floating homes as real property for tax purposes, and generally treat them like real estate. Upon completion of the purchase, Tom will rent out the home, using it entirely as an investment/business use property.

Easement to Delaware Statutory Trust 
Susan owned a commercial property at a busy intersection in her town. Around the corner, there was another small commercial property where the parking lot floods every time there is any substantial rain. To access the nearest storm sewer, that owner needed access across Susan’s property. Susan negotiated for the sale of a perpetual easement for the drain across her property. Susan was advised that the sale of the easement would be fully taxable as capital gains, so she structured the sale as part of a 1031 exchange. Working with her advisors, she reinvested the entire sale price into a Delaware Statutory Trust (“DST”). Read more about <a aria-label="Delaware Statutory Trust 1031 Exchange" href="/blog/delaware-statutory-trusts-1031-exchange-investments" title="Delaware Statutory Trust 1031 Exchange">DSTs</a>.

Conservation Easement 
Joannie owned one of the few family farms left in her part of the county. Encroaching development and increasing costs put pressure on her to sell the property. Because developers placed such high value on the property, there would be a substantial tax bite if she sold the property outright. After consulting with her advisors, Joannie learned about conservation easements. Read more about <a aria-label="Conservation Easements 1031 Exchanges" href="/blog/conservation-easement-delaware-statutory-trusts-using-1031-exchange" title="Conservation Easements 1031 Exchanges">conservation easements</a> in 1031 exchanges. Upon further investigation, Joannie sold a conservation easement restricting future development of her family farm. The sale was structured as part of a 1031 exchange, and she reinvested the proceeds in a nearby condo that she will use as a rental property.

RV Resort 
Nancy and her spouse owned a recreational vehicle resort. Management and maintenance of the resort was a full-time, year-round job. Nancy finally convinced her spouse that they should sell the resort and spend some time traveling around the country. They successfully negotiated the sale of the resort, and on the advice of their tax and legal advisors, structured the sale of the real property portion of the resort as a 1031 exchange. They reinvested the proceeds into several condos near a university, and enlisted the aid of a property management firm to minimize their management responsibilities

Wind & Solar Farms 
David owned a rental condo near his home. His tenants advised him that they would not be renewing the lease, and David had to investigate his options. In the process, his real estate agent presented an offer from a buyer, even before the property was listed for sale. David liked the idea of getting out of the residential landlord business, but did not want to pay the taxes that would be due upon the sale. Working with his advisors, David bought fractional interests in several operating solar and wind farms in several states around the country. The sale and purchase were part of a properly structured 1031 exchange, and took David from one property to a portfolio of properties with existing long-term tenants.

These are examples of a few of the unique opportunities our clients have explored recently. There are many other unique opportunities out there for creative investors, such as oil and gas royalties, mineral rights, water rights, and transferrable development rights, which also qualify for 1031 exchange treatment. Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.

Some of the strategies discussed here may not work in all states, and some states may impose special rules on some of these transactions. As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified Intermediary, such as Accruit, before closing on the sale of the relinquished property.

Metatags:

Title:

1031 Exchanges: Unique Examples of Real Property

03/17/22

Despite leaving real estate as the only asset class, sometimes it is not immediately clear if a type of asset ...

1031 Exchange Holding Period Requirements

03/16/22

If you are considering a 1031 exchange, how long do you have to hold either property before or after the sale ...

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When asking about 1031 Exchange requirements and then considering a 1031 Exchange, people often wonder what the 1031 Exchange time limit is in relation to how long you have to hold the property before and after an exchange for it to qualify. In the article below we cover that very question at length.

<h2>How Long Does a Property Need to Be Held to Satisfy the 1031 "Held For" Requirement?</h2>

Most of the rules and regulations pertaining to IRC Code Section 1031 are found in the detailed <a href="/exchange-library/internal-revenue-service-regulations-irc-%C2%A71031">Treasury Regulations</a> supporting the Code. However, the requirement that exchange assets be held for use in a business or for investment have been part of Section 1031 itself since the inception of this provision in the 1920s.

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment”

As can be seen this excerpt from the Code, this provision applies to both the Relinquished Property and the Replacement Property. This seemingly simple word, “held,” often comes into play in connection with persons trying to determine if their facts will allow for a successful real estate exchange. This requirement often causes confusion for Exchangers and their advisors. A great number of people, including professional advisors, tend to equate it to the necessary time period of one year to convert a gain on the sale of an asset from ordinary income to capital gain treatment. However logical it may seem, in reality there is no connection between the “held for” requirement under IRC 1031 and the time period to create a capital gain.

<h2>Facts and Circumstances Will Determine a Satisfactory Holding Period</h2>

Most exchange expert commentators take the position that a holding of two years or more is so significant an amount of time that it would satisfy the holding period requirement. A revenue ruling was issued by the IRS in 2008 in connection with <a href="/blog/1031-exchange-rules-vacation-homes-primary-residences-and-mixed-use-properties">vacation properties that once were held for personal use</a> but have been converted to use as an investment. In this somewhat analogous case, the IRS provided a “safe harbor” stating that in order to treat the property as an investment, it had to be held in that capacity for at least 24 months immediately prior to an intended exchange.

However, the holding period question usually involves time periods of less than two years. Rather than a bright line rule, such transactions require a facts and circumstances test to determine a satisfactory holding period.

<h2>1031 Exchange Holding Period Examples</h2>

Let’s look at a few examples. Perhaps the question most often asked of a Qualified Intermediary pertains to situations in which fewer than all members of a limited liability company or partnership wish to complete an exchange of Relinquished Property. Sometime prior to the sale, the limited liability company or partnership distributes undivided interests to each of the members or partners and then each one seeks to do his or her own exchange, while others cash out. This is generally known as a <a href="/blog/1031-drop-and-swap-out-partnership-or-llc">“Drop and Swap.” </a>Unfortunately, the individual’s prior ownership interest, as a member or partner in the original entity, does not count towards their new individual ownership, and as a result they cannot be said to have held the property for use in a business or trade. Not only did they hold it for a short period, but they also held it in connection with an intended exchange rather than as an investment.

In contradistinction is the case of an Exchanger selling an investment property and trading into another investment property. In a short period of time, someone knocks on his door and makes him a very attractive offer to sell this replacement property. The facts and circumstances indicate that the Exchanger bought the property with the intent to hold it as an investment. The Exchanger put a tenant into the property (or actively advertised for a tenant) and did not put the property up for sale personally or through a listing real estate broker. Despite the short ownership period, taking advantage of this “offer too good to be true” should allow the Exchanger to exchange this property and roll all the deferred gain into a new property.

As a final example, let’s look at a builder who commonly builds General Dollar stores and sells them upon completion. However, in our example, the builder decides to keep one store and holds it for a few years and then puts it up for sale with the intent to do an exchange. As a rule of thumb, dealers, flippers, rehabbers, etc. buy or build on property with the intent to sell the completed project. Since the held for requirement pertains to the asset and not to the Exchanger or their typical line of work, the builder in this example should be able to do an exchange. Keep in mind, however, that this property would have to be traded for another investment property rather than one that would be intended to be sold.

<h2>Summary</h2>

Under the exchange rules, relinquished and replacement assets need to be held by an Exchanger for investment or for use in a business or trade. The amount of time that an asset must be owned to be able to claim that it was “held” is not a matter of a specific rule, rather it is based upon the facts and circumstances surrounding the disposition and acquisition of the properties.

Updated 3/16/2022.

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1031 Exchange Holding Period Requirements

03/16/22

If you are considering a 1031 exchange, how long do you have to hold either property before or after the sale ...

1031 EXCHANGE GENERAL

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