Near and Long-Term Tax Planning for Section 1031by
Lots of questions continue to swirl around the state of like-kind exchanges (real estate in particular) both in the near and long-term. As a tax planner, it's best to look at the current legislative impact, and the possibilities. Mike Pusey, CPA offers his perspective.
The IRC Section 1031 “landscape” has narrowed significantly and may be further restricted, but likely to remain a critically important element for tax planning purposes.
Even in a more tax-friendly administration, we saw some deterioration in like-kind exchange planning with the exchange of personal property being removed from the scope of Section 1031. The Tax Cuts and Jobs Act generally removed personal property from qualifying for like-kind exchange treatment after 2017.
Interestingly, the only pronouncement one finds in the IRS “PLR bank” dealing with section 1031 during the Biden administration focuses on personal property. To research non-precedential private letter rulings by code section or subject, see this site: irs.gov/written-determinations.
We find a Chief Counsel Memorandum holding that pre-2018 exchanges of certain types of cryptocurrencies did not pass muster as like-kind exchanges. (PLR 202124008, 6/18/21.) The pronouncement’s discussion emphases “character”:
“Treas. Reg. § 1.1031(a)-1(b) defines “like kind” to mean the nature or character of the property and not the grade or quality. One kind or class of property may not be exchanged for property of a different kind or class. For example, an investor who exchanged gold bullion for silver bullion was required to recognize gain in part because silver is primarily used as an industrial commodity while gold is primarily used as an investment. Rev. Rul. 82-166. Similarly, an investor who exchanged one kind of gold coin for another kind of gold coin was required to recognize a gain because one coin’s value was derived from its collectability while the other’s value was derived from its metal content. Rev. Rul. 79-143.”
The focus was pre-2018 because post-2017, personal property exchanges are by statute outside of the scope of tax-free treatment under Section 1031. As tax professionals, we realize tax-free treatment usually comes at a cost – low, carryover basis in the received property. To the extent the deferral translates into eventual step-up in basis at death, the “deferral” becomes tax savings, usually permanent, federal and state.
The author’s best guess is compliance, which may be relatively poor, but keep in mind exchanges of business machinery, including ordinary trade-ins, are now taxable exchanges. As noted in the following, it is possible that taxable disposition treatment, rather than like-kind exchange treatment, may mean deductible losses.
“With no § 1031 treatment available to personal property in 2018, equipment or livestock ‘trades’ will be treated as taxable events, with the taxpayer computing gain or loss based upon the difference between the amount realized on the sale of the relinquished asset and the party’s adjusted basis in the asset. “Amount realized” includes any money, as well as the fair market value of property (other than money) received in the transaction. There will be no tax deferral for §1231 gains or §1245 recapture. There will also be no deferral for a loss.” (“How Does the New Tax Law Impact Equipment
Trades?” Tidgrin, Ag Docket, Perspective on Agricultural Law and Taxation, Center for Agricultural Law and Taxation, 1/16/18).
With the narrowing of the scope of the like-kind exchange benefit, we find real property now being defined, at least for this purpose. See generally the definition of realty for purposes of Section 1031 under relatively recent final regulations. (T.D. 9935, published 12/2/20, as corrected 2/22/21, 86 FR 10457.)
Realty remains the Section 1031 exchange emphasis. For example, co-ownership in some fashion arises frequently with a disparity in the goals of the real estate owners, some wanting to exchange with the tax deferral benefits of Section. 1031.
Section 1031 and co-ownership when only some owners want tax-free exchange treatment can involve such planning as transitioning out of a partnership interest into direct ownership, or even the introduction of multiple partnerships. There are also important Section 1031 considerations with property tax. See “Three Important Areas for 2020 Year-End Tax Planning,” Rojas & Associates, CPAs, 9/30/20, rojascpa.com “Articles” section of the site, “Real Property Taxes” section of the article.
Comparisons of Section 1031 and reinvesting gains in qualified opportunity zones is a current ttopic of discussion. (“Case Study: 1031 to OZ Investment, with Lawrence Jasek,” Opportunity Db, the Opportunity Zones Database, 7/13/22.)
The topic of realty and related parties may generally take on added importance in what may be significant changes in the tax environment – e.g., more concern with gains taxation and transfer taxes. Section 1031 real estate exchanges among related persons may be possible. (See PLR 202053007 (12/31/20)).
Discussions have taken place in affected industries warning that elimination of like-kind exchanges altogether, would hurt the economy. According to a 2020 study, It would “disrupt many local property markets, harm both tenants and owners, and would push offshoring business activity.” (Study by the
Real Estate Research Consortium, “Possible Impact of Repealing or Limiting 1031 Exchange,” SRS Real
Estate Partners, srsre.com).
The emphasis in the Biden proposals is more taxable realty transactions without eliminating Section 1031 altogether. Rather President Biden’s emphasis is on limiting the traditional benefits of Section 1031 in real estate, specifically limiting it to gains that exceed $500,000. All the details of the Biden proposal are not on the table so our discussion is from a general perspective.
For example, in planning for a $500,000 limit, when will we know for sure that the limit will work in a related party context? Moreover, what if there is a gift of realty to family members then the family member has near-term 1031 transfers? How then is there a $500,000 limit, if there is a tax-free transfer into a controlled corporation followed by the corporation’s Section 1031 transfer? (Sec. 351).
Early reports are that the Section 1031 limits would not apply to C corporations, including closely-held corporations. (See “The Biden Administration Proposes Changes to the Taxation of Real Property,” Corn, Friedman, Hamilton, Miller, Nussbaum, Roscow and Halabi, Tax Talks the Proskauer Tax Blog, 5/11/22, proskauertaxtalks.com. See also their discussion of Biden’s realty depreciation recapture provisions).
There is an important 180-day rule when a qualified intermediary is involved in the Section 1031 exchange (Sec. 1031(a)(3)). The following quote is under the heading, “Like-Kind Exchanges Using Qualified Exchange Accommodation Arrangements,” in IRS Pub. 544, “Sales and Other Dispositions of Assets,” for use in preparing 2021 returns.
“The like-kind exchange rules do not generally apply to an exchange in which you acquire replacement property (new property) before you transfer relinquished property (property you give up). However, if you use a qualified exchange accommodation arrangement (QEAA), the transfer may qualify as a like-kind exchange. For details, see Revenue Procedure 2000-37, 2000-40 I.R.B. 308, as modified by Revenue Procedure 2004-51, 2004-33 I.R.B. 294.
Under a QEAA, either the replacement property or the relinquished property is transferred to an exchange accommodation titleholder (EAT), who is treated as the beneficial owner of the property. However, for transfers of qualified indications of ownership (defined later), the replacement property held in a QEAA may not be treated as property received in an exchange if you previously owned it within 180 days of its transfer to the EAT. If the property is held in a QEAA, the IRS will accept the qualification of property as either replacement property or relinquished property and the treatment of an EAT as the beneficial owner of the property for federal income tax purposes.”
As the author writes in July, 2022, one’s Section 1031 tax planning perspective might contemplate timing the 180-day period such that the transaction terminates either in 2022, or early 2023. If President’s Biden’s proposals do get enacted to severely limit the gains eligible for Section 1031 tax-free exchange treatment, any enactment date might be relatively near-term.
But what about the effective date? What specifics might one find in the details of any new law as it describes transactions subject to new limitation? And how will the wording of any effective date affect the 180-day rule in the near-term?
Early reports are of Biden’s proposal being limited to gains from transactions completed after 2021, but what may be the eventual date and its specific terminology given the extensive delays?
Will the measure of Section 1031 retention be limited to $500,000 or $1 million on a joint return per year, or will early reports be modified?
The environment is one of the very significant Biden proposals affecting real property being delayed if not waning, or being subject to major change. Yet our current environment is generally one of increased emphasis on higher taxation, including such particulars as the emphasis on carryovers versus the traditional carryback.
If the Biden concept of limiting Section 1031 realty exchanges to benefit only the year’s transactions within certain gain limits, the prospect is one of taxable gain, tax due in cash, yet the asset received was realty, which the tax collector (usually) doesn’t want. Plus, any mitigation of such tax with a carryback arising from next year’s NOL is less of a factor.
“For most taxpayers, NOLs arising in tax years beginning after 2020 can only be carried forward.” (“Net operating losses,” IRS.gov, irs.gov/newsroom/net-operating-losses.)
The latest mid-July reports of tax increasing provisions in the Senate don’t mention our like- kind exchange topic. (“Senate Democrats make progress with reconciliation package,” Pittman, Wronsky, Dillon, Hobbs, Schiavo, Bakertilly Tax Alert, 7/12/22; https://www.bakertilly.com/insights/senate-democrats-make-progress-with-....)
But if pressures should result in near-term realty exchanges significantly triggering taxable gains, the partial repeal of like-kind exchange treatment will be a primary focus in warning and educating clients.
Like-kind, tax-free exchange of realty is imminently fair and hopefully will remain with us, despite legislative proposals to the contrary. If such a measure does arise, many of the tax professional’s clients will need education, and new planning.
In the author’s opinion (best guess), the prospects of such a major change are less than likely, but certainly a possibility that may accelerate near-term planning under existing rules.
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...