Counseling clients who are contemplating a Section 1031 exchange is never an easy task, mostly due to all of the various possible issues and problems which can arise.
In a 1031 exchange, there are dozens and dozens of rules, regulations and guidelines to follow when it comes to conducting an exchange. This is true regardless of which particular variation your client intends to conduct.
With all of the myriad issues which can come up, many CPAs scratch their heads as they think about the best way they can discuss these transactions with their clients. In this post, we will approach a 1031 exchange by examining it according to its most basic legal elements.
There are four basic elements of Section 1031, stemming directly from the language of the tax code. If you inform clients about these basic rules, you will go a long way toward helping them wrap their heads around how these transactions work and the types of issues which can come up.
Element #1: Eligibility
This means that whatever is intended to be used as the relinquished property must be eligible to use. Under current tax law, this means that the property must be considered “real estate,” as only real property exchanges are presently allowed.
In the past, Section 1031 allowed personal property to be exchanged, but this ended with the Tax Cuts & Jobs Act. A legal element is a requirement of a certain rule. When a dispute arises over whether an element was met, this is when litigation happens.
When it comes to eligibility, a dispute could arise as to whether a given property was actually real property. To better inform clients, try using examples which tend to lie at the borders. For instance, suppose someone wishes to use their boat dock in an exchange.
Is this eligible? In some jurisdictions, it may be. But in others, it’s possible that it could be ruled as ineligible. These kinds of examples may help clients understand the element of eligibility.
Element #2: Like-Kind
The element of like-kind is basically the complementary part of the first element. For a valid exchange to happen, the taxpayer must exchange his or her relinquished property for replacement property which is of a like-kind. In other words, the two properties must be sufficiently similar in their basic nature (but not grade or quality).
Case law shows that this element has been interpreted quite broadly, and so essentially any property which is considered real property will be like-kind to real property. So, as an example, a fee simple interest in a residential rental property will be considered like-kind to a 30+ year leasehold in a commercial building.
Moreover, oil rights may be like-kind to a fee simple interest in a commercial building, provided that the rights are regarded as real property under local law. The main idea is that an exchange must involve a swap of properties which are similar in their basic nature.
Element #3: Held for Business or Investment Purposes
This element is also commonly referred to as the “holding requirement.” For an exchange to be valid, both the relinquished property and the replacement property must be held for business or investment purposes. This is the element which gives taxpayers the most trouble.
Many people have a tough time wrapping their heads around how this requirement works. The holding requirement is not a quantitative requirement, it’s a qualitative requirement.
Many taxpayers ask: how long do I need to hold or own the property? Or, what exactly do I need to do to satisfy the requirement?
The answer is that the holding requirement is satisfied when you are to demonstrate clearly that you had an “intent” to hold the property for business or investment purposes. And intent is derived from all of the facts and circumstances of your specific case. This means that there is no sure way to guarantee that this requirement will be met with 100 percent certainty.
Everything depends on your unique situation. There have been cases where a person was found to have demonstrated intent even though the time of ownership was less than a year. Again, it all depends on the facts of your case.
Element #4: Actual Transfer
This is the easiest element to understand. Simply put, in order to qualify as an exchange, there must be an actual transfer of one property and receipt of another. This element was more significant back before the section (k) Treasury Regulations gave more formality to exchanges.
Earlier cases often had to determine whether what had transpired was in fact an exchange or a “disguised sale” and then a purchase. Courts often ruled that a valid exchange had occurred because an actual transfer had taken place.
In other words, the taxpayer may have used an intermediary to facilitate the exchange, but an exchange still took place because the taxpayer ultimately did receive a replacement property of like-kind. Today, this element is not disputed very often. But, it is still a critical element of the process.
Clients are often wracked with questions and concerns about their upcoming exchange. This isn’t surprising. With 1031 exchanges, there’s a whole lot at stake. Clients often have hundreds of thousands and even millions of dollars of gains tied up in their property.
A collapsed exchange could translate into huge tax liabilities. Introducing clients to these four main requirements of exchanges will do a lot to give them a sense of what’s going on.