Mackay, Caswell & Callahan, P.C.
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Counseling Clients on the Risks of Unusual Replacement Properties

A Section 1031 exchange can be completed by acquiring a wide variety of different replacement properties.

Sep 19th 2019
Mackay, Caswell & Callahan, P.C.
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Pokeno Property Management
Pokeno Property Management

Although a good portion of 1031 exchanges are completed by acquiring a replacement property which mirrors the relinquished property, this isn’t always the case.

Currently, when it comes to real estate, Section 1031 tax law provides wide latitude when it comes to what sort of replacement properties qualify as “like-kind” to relinquished property. Taxpayers have exchanged all kinds of unusual properties. If you have a client preparing to conduct an exchange, they may be concerned about the eligibility of their prospective replacement property. Fortunately for taxpayers, the interpretation of the like-kind requirement is quite broad, and so taxpayers have a lot of leeway when it comes to selecting a potential replacement. 

In this post, we will discuss the potential risks involved with selecting unusual replacement properties in an exchange. For now, as long as the prospective property is considered “real property” under local law, then it will qualify as like-kind to relinquished property.  

The Like-Kind Requirement is Critical

As we’ve mentioned in an earlier article, the like-kind requirement is one of the four basic elements of Section 1031 law. The other three elements are actual transfer, eligibility, and the holding requirement. Simply put, your client needs to satisfy the like-kind requirement in order to have a successful exchange.

And there’s no way to bend or modify the requirement; either the replacement property qualifies as like-kind, or it doesn’t. Like the other three basic requirements of Section 1031, the like-kind requirement is rigid.

The good news is that the like-kind requirement is interpreted broadly. This means that your relinquished property and your replacement property don’t have to be superficially similar to qualify as like-kind.

If your client owns a residential rental property, they can choose raw land, a commercial building, an interest in a Delaware statutory trust, a 30 year leasehold interest in real estate, or another type of property and satisfy the like-kind requirement.

Replacement Property Must Be Real Property Under Local Law

The like-kind requirement is broad enough that it raises the question of where exactly the boundaries kick in. One useful guideline is that the like-kind requirement only refers to the nature of the property, rather than its quality or grade.

So, as long as the property itself is classified as real estate, then it should be eligible as replacement property. The IRS has issued documents to clarify a number of edge cases which seemed to push the boundary of the like-kind requirement.

For instance, the IRS has issued private letter rulings and revenue rulings in cases involving easements, which are temporary rights to real property. In PLR 9232030, for example, the IRS ruled that a perpetual agricultural conversation easement was like-kind to a fee interest in real property.

The IRS has issued documents in cases which involve water rights, oil rights and other interests in valuable materials. The general guideline is that a royalty interest is like-kind to real property. 

As would be expected, clients will need to seek specialized counsel if they have a case involving one of these unusual properties. Thus far, however, Section 1031 tax law has upheld the principle that whatever is considered real property under local law (of the area housing the replacement property) will qualify as like-kind real property for purposes of Section 1031. This gives taxpayers wide latitude. If your clients want to expedite the process of determining the status of his or her target replacement property, he or she should check its status under the applicable state or local law.

Unusual Replacement Properties Carry Some Risks

As the existing body of Section 1031 case law and IRS statements show, not all rights or interests in property are eligible as replacement property. There have been numerous judicial opinions which denied like-kind qualification when an unusual property was selected.

If your client selects an unusual replacement property, there may be some degree of risk, especially if the unusual property hasn’t been scrutinized by the IRS or the courts. This is true even if that unusual property appears to be classified as real property under local law.

The reason for this is because there could always be a legal challenge by the IRS, and there is a possibility that the courts may narrow the interpretation of like-kind in a given situation. It’s always possible that a court may deny recognition of a given property as real property, even if local law holds otherwise, because the court things that the interpretation has become too broad in a given case. 

Given what is at stake, be sure that your client seeks out a competent tax attorney in this area so that he or she can be properly counseled on the risks and probability of collapse. The IRS will challenge a case if it thinks that it has a good chance of success. Moreover, a replacement property which stretches the common sense interpretation of like-kind may be successfully impugned.

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