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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 residence.

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 1031 exchange:

  1. 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.)
  2. 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.
  3. "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.
  4. 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 days.

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.


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