The concept of a I.R.C. § 1031 Exchange (hereinafter “1031”), a like-kind exchange or a Starker exchange (it goes by many names), has existed for over 100 years. Originally a two-party, simultaneous transaction, the 1974 Starker case, the 1984 Tax Reform Act and 1991 Treasury Regulations formally sanctioned the delay between the relinquished property disposition and the replacement property acquisition. A more recent and significant change occurred in 2018 via the Tax Cuts and Jobs Act (“TCJA”), which repealed the exchange of all personal property and intangible property. Only real property may be exchange post TCJA.
The purpose of the 1031 Exchange is to defer the recognition of capital gains, depreciation, state and net investment income taxes. It allows investors to continue their investment, much like a I.R.C. § 401k does for stocks.
Four Statutory Requirements:
Real Property
Final regulations were issued in December of 2020, providing tests to determine if an asset qualifies as real property for 1031 Exchange purposes. If an asset is treated as real property within the state it is located, it will be real property for 1031 Exchange purposes. For example, New York treats cooperative apartments (despite being a lease and stock in a corporation), as real property. Alternatively, one can look to a listed asset test. It offers exhaustive list of assets, including land and improvements to land, which are treated as real property.
Qualified Use
The real property must be held for investment or for productive use in a trade or business. This is a question of fact and ultimately comes down to the taxpayer’s intent. Such intent may be established by a lack of intent to liquidate the investment (flippers), or lack of intent to use the property personally. A variety of cases have provided guidance on personal use including a Revenue Procedure, which provides a safe-harbor for second homes.
Like-Kind
The like-kind requirement is quite flexible in the context of real property. With limited
exception, all real property is like-kind to all other real property. When exchanging personal
property assets pre TCJA, it was necessary to look to The North American Industry Classification System to determine if assets were like-kind.
Exchange
To have an exchange, as opposed to a sale, it is imperative that a Qualified Intermediary (“ǪI”) provide the necessary documents prior to the closing of the relinquished property. Unfortunately, taxpayers regularly seek to set up exchanges post-closing, only to learn that they have a taxable sale and not an exchange.
Some other important rules
Within 45 calendar days following the sale of the relinquished property, the taxpayer must identify replacement property. The three-property rule is the most commonly used identification method. It allows the taxpayer to list up to three potential properties without regard to their fair market value. In the event the taxpayer wants to list more than three, the 200% rule allows a taxpayer to identify four or more properties. However, when the fair market value of the identified properties are added together, the total fair market value cannot exceed two hundred percent (two times) the sale price of the relinquished property. Lastly, the 95% rule allows a taxpayer to identify four or more properties regardless of fair market value. However, the taxpayer must acquire 95% of the fair market value of all the identified property. This might be accomplished in a portfolio acquisition where it is an all or none acquisition. Regardless of the identification method, in the event the taxpayer is not purchasing 100% of a property, it is advisable that the property be described by either the percentage interest to be acquired, or the fair market value of the interest to be acquired (i.e. in the case of a tenancy in common purchase or an interest in a Delaware Statutory Trust).
There are many misconceptions around the equity and debt requirements to maximize the gain deferral. To fully defer the realized gain from the sale, all the net equity must be sent to the ǪI. All equity must be reinvested in replacement property and any mortgage paid off on the relinquished property, must be replaced. Investors are not forced to take another mortgage and are free to replace debt with new equity. Some investors think they only have to re-invest the equity while others think that only the gain needs to be re-invested. Failure to spend all the net equity and/or replace all the debt, will result in “boot” (tax). A term which does not appear in the code or the regulations.
Qualified Intermediary
Anyone serving as a taxpayer’s agent in the two years preceding an exchange (including the taxpayer’s attorney, accountant or realtor), is a “disqualified person” and prohibited from serving as the ǪI. The ǪI becomes the party with whom the taxpayer exchanges their properties. In this role, the ǪI provides documents that comply with the Regulatory requirements and holds the taxpayer’s sale proceeds until the funds are redeployed into replacement property.
The ǪI holds the taxpayer’s funds subject to specific limitations to meet the Regulatory requirement that the taxpayer not have constructive or actual receipt of the proceeds. Specifically, the taxpayer cannot have the right to receive, pledge, borrow, or otherwise obtain the benefit of the sale proceeds until specific events occur:
- If the taxpayer does not identify replacement property or has acquired all replacement property, within the 45-day window, on day 46 the restrictions are lifted, and the funds can be released.
- If the ǪI is holding funds on day 181, the restrictions are lifted, and the funds can be released.
- After the 45th day, once the taxpayer has received all of the identified replacement property to which it is entitled, the restrictions are lifted, and the funds can be
Delaware Statutory Trusts
Delaware Statutory Trusts, referred to as DSTs, are a common replacement property strategy. Approved by the IRS in 2004, DSTs allow a taxpayer to invest in institutional grade properties on a co-ownership basis. The taxpayer buys beneficial ownership interests in a trust which holds the real property. Unlike typical real estate investments, DSTs are sold as private placements through licensed advisors, not real estate agents. Investors must meet certain net worth or income requirements to be eligible. There are a variety of asset classes available, and they are often leveraged to provide debt replacement options as part of the exchange. These passive investments can be used as a backup to a primary acquisition or to replace unallocated equity and/or debt.
For a complimentary consultation on 1031 matters, please contact Eric Brecher, Esq., CES® at