New Tax Bill Protects 1031 Exchanges for Real Property

By Michael W. Hurwitz  |  January 15, 2018

Trump-era tax reform is underway with the passage of the Tax Cuts and Job Act of 2017 (H.R. 1). Under the bill, 1031 like-kind exchange has been preserved, despite previous hints at its elimination. However, the legislation does limit deferral of gain on like-kind exchanges exclusively to real property as of January 1, 2018.

This is a victory for commercial real estate owners and investors who can continue to utilize the strategy for tax-deferral purposes. In light of this renewed opportunity, it’s a good time to review the specific rules surrounding 1031 exchanges.

Requirements of a 1031 Exchange

IRC Section 1031(a)(1) provides that “no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like-kind that is to be held either for productive use in a trade or business or for investment.”  

It is important to note that: (1) both the property surrendered/relinquished and the replacement property received must be held either for productive use in a trade or business or for investment; (2) the property surrendered and property received must be of “like-kind” (nature and character of property); and (3) the exchange must be a reciprocal transfer of properties (as distinguished from a sale and a repurchase).  

Important Timeframes

Certain time periods for both identification of replacement property and the ultimate completion of the acquisition of such replacement property are specified in IRC Section 1031(a)(3). The basic rules surrounding these deadlines are as follows:

• 45 calendar days to identify replacement property.
• 180 days to close the entire transaction.
• Above deadlines are firm regardless of whether the date falls on a holiday or weekend (in other words, no extensions).
• The timeframes start when the benefits and burdens of ownership are transferred.

Identification of Replacement Property

Pursuant to Treasury Regulations 1.131(k)-1(c)(3), a replacement property is considered “identified” only if it is unambiguously described (i.e. legal street address or description) in a written document or agreement.  The identification of replacement property must utilize one of the following three methods: 

• Three Property Rule – one to three properties are identified;
• 200% Rule – any number of properties can be identified, provided that the aggregate fair market value of identified replacement property does not exceed the fair market value of the surrendered property; or
• 95% Rule – any number of properties can be identified, provided that the acquisition of the replacement property represents 95% of those properties identified.

Common Pitfalls

There are many issues that can trip up an uniformed taxpayer contemplating a deferred exchange. Some of the more common issues include:

• Surrendered property is not held for productive use in a trade or business or for investment.
• Taxpayer has constructive receipt of cash from sale of surrendered property.
• Replacement property is held for personal use.
• Replacement property is not like-kind.
• Identification periods are not respected.
• Qualified intermediary is a disqualified person.
• Taxpayer does not reinvest all of the proceeds from the sale of the surrendered property (a/k/a cash or debt relief boot).

Holding Periods

While it is not clear how long one must hold the property, the IRC and related Treasury Regulations imply a continuity of ownership.  There is a very thin line between real property held for sale (non-qualifying/dealer-type property) and real property held for investment (qualifying/investor-type property).  Pursuant to IRC Section 1031(a)(2)(A), like-kind property excludes property primarily held for sale. 

Distinguishing Dealer from Investment Property

There is no bright-line test or magic formula to determine whether a property is held for sale or for investment purposes. Generally, the determination is made based on the taxpayer’s intentions and the situational facts and circumstances. 

If a taxpayer purchases property with the intent to sell, the taxpayer will be considered a "dealer" of such property. In contrast, if the taxpayer purchases property intending to hold it for the ongoing rental income and future appreciation benefits, the more favorable investor status should apply. The following factors have been established by the tax courts over the years to distinguish dealer from investment property:

1. Nature, intention and purpose of the acquisition of the property (i.e. taking steps as a dealer to promptly flip and cash out on its resale, or holding as an investor for either passive rental income property or for ultimate resale as a portfolio asset at a profit);
2. Duration of the ownership;
3. Extent and nature of the taxpayer’s efforts to sell the property;
4. Use of the property at the time of the sale;
5. Frequency, continuity and substance of the owner’s sales of other properties;
6. Extent of subdividing, developing, construction of improvements, planning, zoning efforts and advertising;
7. Time and effort habitually devoted by the taxpayer to the sales; and
8. Character and degree of supervision and control exercised by the taxpayer over any representative selling period, the extent of advertising for buyers, listing the property for sale and other promotional sales activities.

As a result of the voluminous body of case law in this area, the tax courts have warned taxpayers that each transaction must be decided on its own merits and the particular facts and circumstances of each contemplated transaction.

Any consideration of a 1031 exchange needs to take into account all of the pros and cons of tax deferral and the specific circumstances surrounding the property and its potential replacement. Remember, no single factor or combination of factors will be controlling in all situations.

About Michael W. Hurwitz