1031 Exchange Blog

Taxpayers who own real property in a business or for investment consider a 1031 exchange when selling and replacing with “like-kind” property. The alternative is to pay the federal and state capital gain and depreciation recapture tax that can represent up to 40 percent of the sales price. A 1031 exchange defers or postpones the recognized gain or tax due if a series of rules are followed. The tax is eventually due when the replacement property is sold and another 1031 exchange is not initiated. The 1031 exchange allows those otherwise paid tax dollars to be used as interest free working capital towards the replacement property acquisition.

Ineligible for 1031 Exchange

Any real property held in the productive use of a business or for investment is eligible for 1031 consideration. Land can be exchanged for commercial property or a multitude of other types of real property. The following is ineligible for a 1031 exchange:

• Primary residence

• Indebtedness

• Inventory

• Stocks and Securities

• Partnership Interests

Partnership Interests

The legal definition of partnership interest is “an association of two or more persons to carry on as co-owners a business for profit.” Partnerships may contain individuals or corporations. In 1984, partnership interests were excluded from non-recognition treatment under Internal Revenue Code § 1031; however, there are a couple of exceptions.

Revenue Ruling 99-6

Per the Omnibus Budget Reconciliation Act of 1990, “an interest in a partnership that has in effect a valid election under Internal Revenue Code (I.R.C.) Section 761(a) to be excluded from the application of all of subchapter K is treated for purposes of I.R.C. § 1031 as an interest in each of the assets of the partnership and not as an interest in a partnership.”

Revenue Ruling 99-6 allows a taxpayer in a 1031 exchange who is already a partner in the partnership to purchase all of the remaining interests of the other partners in the partnership. For example, if Jack and I are 50/50 partners in a partnership that owns the replacement property, Jack who has initiated a 1031 exchange, can buy my interest as replacement property. Under Revenue Ruling 99-6, the acquisition is treated as if the partnership first liquidated, then Jack, acquired a 50 percent interest in the underlying real estate.

Revenue Ruling 99-5

Per Rev Ruling 99-5, “if a taxpayer owns 100 percent of a disregarded LLC and the taxpayer sells a portion of the LLC interests to a buyer, the taxpayer is treated as if it first sold an undivided interest in the assets of the LLC and the taxpayer and the buyer then contributed their undivided interests to a new partnership. Therefore, the sale of the LLC interests by the taxpayer could be structured as an exchange by the taxpayer of an undivided interest in the underlying property.” A buyer acquiring a portion of the LLC interests is considered as a contribution to the new partnership, qualifying the LLC interests as replacement property in a 1031 exchange given the buyer acquires the interests to hold in the productive use of a business or for investment and not for flipping or for profit.

Drop and Swap

Partnerships experience challenges when, following the decision to sell the underlying property, one partner wants to cash out and the other wants to defer the gain in a 1031 exchange. The same taxpayer requirement of the 1031 code requires the taxpayer who sells to be the taxpayer who buys. With proper planning as far in advance of the purchase and sale agreement, one option is to dissolve the partnership, dropping title from the partnership to the individuals or tenants in common. Once as tenants in common, one taxpayer can cash out while the other taxpayer defers their gain in a 1031 exchange.

Dissolving the partnership should be reviewed with your CPA or tax attorney. Attention should be given to IRS Form 1065, questions 13 and 14. Dropping too close to the closing date may cause the IRS to question the 1031 exchange given the short time the new titleholders hold the property.

Download “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking here.

A Section 1033 eminent domain and a Section 1031 exchange achieve the same outcome of deferring capital gain taxes when selling real property, but one is far less restrictive than the other. Section 1033 does not require a Qualified Intermediary (QI) where in a Section 1031 exchange a QI is required with the exception of a two-party exchange. In a Section 1033, the taxpayer can receive the sales proceeds and hold them until the replacement property purchase. If not all the proceeds are used towards the acquiring the replacement property, the taxpayer is taxed on the difference. In addition, replacement property cannot be acquired from a related party. Section 1033 applies when the relinquished or current real property is sold due to condemnation or a threat of condemnation.

An example of a Section 1033 condemnation is when the state wants to acquire your land or property for road improvements or development. Commercial property owners are typically the parties receiving the notice to acquire their properties from the state and often from the Department of Transportation. It is important to secure a letter from the condemning party that reflects their authority to condemn and if the property is not sold willingly, the property will be condemned. Finally, the letter should clearly indicate the signor is authorized on behalf of the condemning entity.

IRC 1033 Functional Use Standard

In a Section 1031 exchange, the relinquished property is replaced with “like-kind” property within 180 calendar days post-closing. The taxpayer cannot have access to the exchange funds. In a Section 1033, the taxpayer decides to use one of two standards for the type of replacement  property. The first choice is that the replacement property must have the same functional use of the property condemned. Land must be exchanged for land, rental must be exchanged for a rental and commercial property held in a business must be exchanged for property held for business use. Land already owned by the taxpayer can be improved with Section 1033 proceeds. “The replacement property must be acquired during the period that begins from earlier of the date of the disposition or of the threat or imminence of condemnation of the converted property, and ends two years after the closed of the first taxable year in which any part of the gain upon the conversion is realized,” per IRC Section 1033(a)(2)(B).

IRC 1033 Like-Kind Use Standard

Similar to the “like-kind” standard in Section 1031, this method can also be chosen to define the replacement property in a Section 1033. “Like-kind” means property held in the productive use of a business or for investment is to be replaced with property held in the productive use of a business or for investment. Under “like-kind” standard, “the replacement property must be acquired during the period that begins from the earlier of the date of the disposition or the date of the threat or imminence of condemnation of the converted property, and ends three years after the close of the first taxable year in which any part of the gain upon the conversion is realized,” per IRC Section 1033(g)(4).

Section 1033 is similar to Section 1031; however, the taxpayer is permitted to hold the exchange proceeds — no QI is required — and reinvest using one of two standards within two or three years.

To learn more about 1031 exchanges, review the following articles:

• How to 1031 Exchange

• Three Reasons Why to 1031 Exchange

• 1031 Exchange Steps to Consider

If you have a specific question, click on the button on the right hand side of the page for a response from the Certified Exchange Specialist on staff. Download a 10 point 1031 exchange checklist by clicking here. If you have a comment, we would enjoy hearing from you. If you have any questions, feel free to reach out to us via the options on the top right of this page, call our office at 800-227-1031 or contact us via email here