Fall 1998: 1031 Exchanges
By Michael J. Festa
Even with the recent reduction in the capital
gains tax, I still receive numerous inquiries from prospective sellers
on how to minimize or defer the payment of such tax. This article
revisits the tax deferred exchange discussed in previous newsletters.
As always, we must begin our discussion by
differentiating the IRC Section 1031 Exchange from the $250,000.00/
$500,000.00 deduction now allowed on the sale of the taxpayer's principal
Under prior tax law, (IRC Section 1034 -- the
residential property rollover) the taxpayer was allowed to sell his
or her principal place of residence and purchase a replacement residence
(and construct improvements) within twenty-four months, either before
or after the sale. As long as the acquired property was of equal or
greater value than the adjusted sale price of the disposed property,
any gain realized on the sale of the old property would be deferred.
Recent changes to the tax law have eliminated
this Section 1034 rollover. A single taxpayer is now allowed a $250,000.00
deduction, and a married couple, a $500,000.00 deduction, on the sale
of his/her/their principal residence. As before, however, neither
the old residential property rollover, nor the new tax law, allows
loss to be recognized on the sale of one's principal place of residence.
Section 1031 applies to property "held" for
trade, business or investment, "exchanged" for "like
kind" property also to be "held" for trade, business
or investment. Remember, if your principal residence also produces
income (e.g., a duplex or home office) you will need to allocate the
sale price as between that portion used for residential purposes and
that portion producing income. Let's look at the elements of the Section
- What is "like kind" property?
Efforts by the IRS a few years ago to narrow the scope of the
definition of like kind property failed; therefore, like kind
property can be any other real property, provided it is used
for trade, business or investment. Thus, for example, an apartment
building can be exchanged for vacant land, or an industrial building
can be exchanged for a rental house. (On the other hand, an interest
in a Partnership that owns real estate cannot be directly exchanged
for real estate, since Partnership interests do not constitute
an interest in real property, and are thus not "like kind".
Exchanging out of partnerships is thus a matter which requires
very careful and very special planning.)
- Both properties,
the one which is to be disposed of (the "down leg")
and the one to be acquired (the "up leg") must both
be "held" for a sufficient duration. How long must
each property be held? There is no clear-cut definition from
the IRS; however, tax advisors generally believe that a minimum
hold of 6 months, if not more, is necessary to show the proper
intent. The burden is on the taxpayer to demonstrate the intention
to hold, for investment or income, both properties, and to show
that the exchange was not simply some kind of "step transaction" preconceived
to result in the cashing out or sale of the down leg property.
- "Boot". Complex number crunching
is involved when the taxpayer wants to pull cash out of either
transaction; often the receipt of cash results in taxable boot
(i.e., non-like kind property). The calculations involved in
the determination of boot (and the offsets that can reduce or
eliminate boot) are beyond the scope of this article; nonetheless,
a general test is that, in most instances, there will be a totally
tax-free exchange if the taxpayer is trading even or up both
in fair market value and in equity. The presence of some boot
does not, however, defeat an otherwise proper exchange; in such
event, the transaction will only be taxable to the extent of
the net boot received.
- There can be no "sale" and "repurchase".
There must be an "exchange", whether simultaneous or
delayed. The taxpayer enters into an exchange agreement with
a third party accommodator, which then acts as the "seller" of
the down leg property. As the "seller", the accommodator
will receive and deposit the net sale proceeds, from which the
taxpayer will then designate, and the accommodator will buy,
the replacement property. The key time requirements are the identification
of the replacement property within 45 days of the close of the
down leg, and the "purchase" of the up leg within 180
Reverse Starker Exchanges allow the taxpayer
to acquire his or her up leg prior to disposition of the down leg.
The mechanics of the Reverse Starker differ substantially from the
typical delayed exchange, and give rise to issues beyond the scope
of this newsletter.