Section 1031 is undoubtedly among the most powerful tools for taxpayers in our tax code. If performed correctly, a 1031 transaction will allow a taxpayer to use deferred capital gain taxes to acquire more business or investment property.
The TCJA removed personal property transactions from Section 1031, so now taxpayers can only defer capital gain taxes derived from real estate. But, even with this more limited scope, it is still an extremely useful provision of the code.
Because of its usefulness, CPAs can stand out from the crowd by familiarizing themselves with the basics of the 1031 exchange process. Tax-deferred exchanges tend to be fairly complex. No matter which variation, all involve a number of rules. And, depending on the transaction, certain ones can present risks and require legal counsel.
In this post, we will discuss how CPAs can provide counsel to clients regarding receipt of replacement property in these transactions. In many cases, concerns will not surface during the course of a transaction, but accounting professionals can solidify their client base by providing guidance in this area whenever this issue arises. CPAs can offer basic counsel and then point individuals in the direction of competent legal assistance to give additional reassurance.
First, be aware there are several variations of 1031 transactions. In the simplest, the so-called “deferred exchange,” counseling clients on receipt is fairly straightforward. There are a few bright line rules and then an additional one that is somewhat subjective.
Here are the bright line rules:
(a) replacement property must be received before the end of the 180-day timeline
(b) replacement property received beyond the 45-day identification timeline must have been properly identified
(c) replacement property received prior to the end of the 45-day identification timeline is treated as property that has been properly identified
From these three bright line rules, we can discern a few ways in which CPAs can provide useful counsel for clients. For one, whenever possible, clients should try to acquire replacement property prior to the end of the 45-day identification period. Doing so will eliminate both the need to identify and the possibility of the exchange collapsing. Many end up failing because taxpayers either forget to identify property or fail to acquire it before the end of the exchange period. Acquiring property within the identification period takes care of both of these concerns.
The other, more subjective, rule pertaining to receipt in deferred exchanges is the rule that received property must be “substantially the same” as the property identified. Identification involves a physical description and also an approximation of the fair market value. If the property that is received differs too much from either of these identifiers, the exchange may collapse.
This rule is more subjective because there is no clear guideline for determining what makes something “substantially the same.” There is some information in the Treasury Regulations on this topic, but no definitive standard or set of standards.
In addition to the traditional deferred exchange, there is also the “improvement exchange.” These involve one or more replacement properties that have yet to be produced or fully completed.
CPAs can really help their practice by providing guidance on receipt of these transactions. Improvement exchanges are quite common, and taxpayers who conduct them very often have concerns related to receipt. The Treasury Regulations give special guidance on identifying improved property. Under Section 1031(k)-(1)(e)(2)(i), taxpayers must include as much detail as is “practicable” of the improvements at the time the ID is made. This is in addition to the standard physical description which is also required for deferred exchanges.
Section 1031(k)-(1)(e)(3) applies directly to receipt of improved property. As with unimproved property, correct receipt requires that the received property be substantially the same as identified.
However, this “substantially the same” requirement also applies to the improvements being made. This means that a taxpayer will need to ensure that the proposed constructions go as planned, as any deviations could cause the transaction to fail. If, for instance, a client decides to include many more improvements to a property than were included in the original identification, this will likely result in the collapse of the exchange.
For the purposes of identifying improved property, the property’s fair market value is its approximate value at the time it is expected to be received. Hence, CPAs can counsel clients to make sure whatever improvements they identify are indeed included in the property they ultimately receive.
For CPAs who have clients conducting improvement exchanges, these pieces of advice on receipt will prove to be quite valuable. Improvement exchanges are more complicated and therefore tend to produce more anxiety. If accounting professionals can alleviate at least some of this anxiety, they will go far toward increasing client satisfaction and improving their overall practice.