1031 Exchanges: Their History and Uses by Steven W. Hickox
1031x.com is a full service 1031 exchange accomodator. Since 1994, we have assisted thousands of clients with their tax-deferred, like-kind real estate exchanges. The following article will tell you something about 1031 Exchanges, their History and Uses.
Internal Revenue Code Section 1031 provides a unique opportunity to DEFER payment of INCOME TAX when it would otherwise be payable. Income tax on the profit or “gain” from the sale of property is usually imposed when the property is transferred. IRC section 1031 is an exception to this rule.
Between about 1920 and 1970 “1031 exchanges” were always simultaneous swaps between two parties.
In 1970 the STARKER family sold their timber land in the Pacific Northwest to Weyerhauser Company. When they sold the property they crafted a trust agreement wherein the EXCHANGE PROCEEDS would be held by the buyer, Weyerhauser, in a separate bank account. The terms of the trust provided that Weyerhauser would use the funds to purchase REPLACMENT PROPERTY for the Starker family and for no other purpose. The trust agreement limited the Starker family access to the funds except for the purpose of buying replacement property.
When the IRS saw this, it denied 1031 tax deferral to the Starker family. The IRS argued that 1031 exchange meant the swap of property between two parties. The IRS could see that if property could be sold to one person and bought from another, in a 1031 exchange, then the application of the law would become much more wide spread. Since the job of the IRS is to raise taxes it fought hard against the Starker’s trust arrangement. In a monumental and far reaching decision the tax court ruled in favor of the Starker family and against the IRS. To this day, in a tribute to this family, 1031 exchanges are often still called “Starker Exchanges.”
Of course the IRS was right. As soon as 1031 exchanges could be done as three party exchanges then they were much more practical for the Exchanger. Instead of having to find someone willing to swap property, you could now sell to one and buy from another. The use of section 1031 to defer income taxes has mushroomed.
In 1991 the IRS issued regulation (Reg. Sec. 1.1031). These regulations extend for about 100 pages. They are designed for one purpose: To contend with the loss to the Starker family. They do this in two ways. 1) They establish a trust like procedure for escrowing the sale proceeds and, 2) They create a myriad of rules to limit an Exchangers ability to successfully qualify for tax deferral.
In sanctioning the Starker procedure, the IRS created “Qualified Intermediaries.” The name “Qualified Intermediary” was unknown in the vernacular until the IRS put the two words together. Together they have only one meaning: a person or company escrowing the funds from the sale of relinquished property during an IRC section 1031 exchange. The Qualified Intermediary plays the same role today that Weyerhauser Company played for the Starker family. The QI must hold the money, deny access to the money to the Exchanger, and use the money to buy replacement property, as directed by the Exchanger. A written Exchange Agreement governs the relationship of the QI and the Exchanger.
The nitpicky rules of 1031 exchanges will come next. Remember, these rules are designed by the IRS to make 1031 exchanges difficult to complete. For that reason they do not make any sense. You cannot reason your way through this process.
1. Both the relinquished property and the replacement property must be held for a qualified purpose. Both must be held for investment or for use in trade or business. Gray areas include: vacation homes and homes occupied by relatives. Dual use properties, properties which you occupy as your principal residence and also hold for investment, usually qualify for 1031 exchange treatment on the portion held for investment.
2. Prior to the sale of the relinquished property the Exchanger must have written exchange agreement with QI. This agreement must, in particular, limit the Exchanger’s access to the proceeds from the sale of the relinquished property. The proceeds can only be used to buy qualified replacement property or become taxable. If the Exchanger receives “constructive receipt” of the proceeds then the tax deferral fails. Constructive receipt means legal access to the funds even if not used.
3. The replacement property must be of equal or greater value than the relinquished property. If the Exchanger trades down in value then tax will be paid on the difference but, limited by the total amount of gain in the transaction.
4. All of the cash proceeds from the sale of the relinquished property must be reinvested in the replacement property. If the Exchanger receives some cash and reinvests some cash then the 1031 exchange does not fail in its entirety. Instead it becomes are partially tax deferred exchange. The Exchanger will pay tax on the cash removed from the transaction again limited by the total amount of gain in the transaction.
5. Any cash taken out by the Exchanger is taxable. Therefore as the Exchanger takes increasing amounts of cash out the tax deferral decreases and the exchange becomes less valuable to the Exchanger. At a certain point the Exchanger’s cash out equals his gain in the transaction and the exchange becomes of no value at all.
6. Generally, as long as both parcels of real estate are held for a qualified purpose (rule 1 above) then all real estate is "like-kind" to all other real estate. This means that you can sell a ranch and buy a mobile home park or sell a conservation easement and buy an oil well. This rule allows you to change the nature of your real estate investment and still qualify for tax deferral. This makes 1031 exchanges a very powerful investment tool.
7. The Exchanger that sells the relinquished property must become the buyer of the replacement property. This may seem like an obvious rule but, it sometimes creates great difficulty. If a multiple owner limited liability company or a corporation owns the relinquished property then that entity must also own the replacement property. The owners of the company cannot own the replacement property in their individual names. What if some owners want to do a 1031 exchange and some do not? What if the lender requires that an individual own the replacement property?
8. It is OK to exchange multiple relinquished properties for one replacement property or vice versa. An Exchanger may also sell 100% of the relinquished property and buy only 5% (for instance) of the replacement property. This rule creates interest possibilities with regard to selling 100% of a small property and buying a larger property with other like minded investors as tenants in common. This rule is also a powerful investment tool.
9. If you carry back financing on the sale of the relinquished property then you will be taxed on the principal amount when you receive it. The 1031 exchange can proceed on the remainder of the transaction. Other interesting ways of handling owner carry back financing exist. These can increase the tax deferral of the 1031 exchange and decrease the tax on the carry back.
10. The Exchanger may sell the relinquished property to a related party but, thereafter, the related party may not sell that property for two years. The Exchanger may not buy replacement property from a "related" party. The IRS treats related parties as the same taxpayer in a 1031 exchange. If the Exchanger sells to an unrelated party and buys from a related party the IRS treats this as having sold and having not purchased at all.
11. A 1031 exchange is a tax deferral strategy. If a 1031 exchange is completed and, subsequently the replacement property is sold without a new 1031 exchange then the gain from both transfers is recognized (taxed). In order to keep track of this, the basis of relinquished property is carried forward into replacement property. The easiest was to calculate the basis in the replacement property is to start with its purchase price and reduce this by the amount of gain on which tax have been deferred in the 1031 exchange.
12. Use of exchange proceeds to pay down on a mortgage on a property that you already own is not considered a “like-kind” exchange. Making improvements to a piece of real estate that you already own with exchange proceeds is not considered a “like-kind” exchange. However, there are certain procedures whereby a holding company buys the replacement property, makes the improvements, and transfers the improved real estate to you, which can accomplish this goal.
12. The Exchanger must identify the replacement property within 45 days from the transfer of the relinquished property. The identification must be in writing signed and dated by the Exchanger. The indemnification must be transmitted within the 45 days stated above. It must be transmitted to someone involved in the exchange (usually the Qualified Intermediary) and not an agent of or related party to the taxpayer.
13. The Exchanger must receive transfer of the replacement property within 180 days of the sale of the relinquished property.
In Rev. Proc. 2000-37 the IRS sanctioned what have become known as “Reverse 1031 exchanges, In addition to complying with rules 1-11 above, in a reverse 1031 exchanges the Exchanger must:
1. Not hold title to both properties simultaneously. Instead a real estate holding company is created to hold title to either the relinquished property or the replacement property. These real estate holding agreement are known as: “Qualified Exchange Accommodation Arrangements” and, the entity created to hold the property is known as an “Exchange Accommodation Titleholder.”
2. The Exchange Accommodation Titleholder cannot hold title to either property for more than 180 days.
3. ID Old property within 45 days if New property is "parked".
4. Provide funding to purchase New property. Financing issues loom large in reverse 1031 exchanges. The money from the sale of the relinquished property is not available as the down payment for the replacement property. Therefore only financially capable exchangers can succeed with reverse 1031 exchanges. Fees charged by Qualified Intermediaries to perform reverse 1031 exchanges are substantially higher than for forward 1031 exchanges.
This information is provided as a primer to 1031 exchanges. Each exchanger’s circumstances are different and your circumstances may not qualify for tax deferral.
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