Creative Uses for Tax Deferred Exchanges

Colorado Real Estate Journal, October 20, 2000

Section 1031 of the Internal Revenue Code permits non-recognition of gain on exchanges of like-kind property that is held for productive use in a trade or business, or that is held for investment. When the predecessor to Section 1031 was enacted, Congress apparently envisioned straightforward simultaneous swaps-I give you my truck or my apartment building, and you give me like-kind property of yours, with or without cash "boot" to even up value differences. A creative taxpayer named Starker changed all that in the late 70's. He transferred unencumbered timber property to his buyer in exchange for an unsecured promise from the buyer to transfer like-kind property chosen by him during the five year period after the sale. The court found that a tax deferred exchange didn't have to be simultaneous, and upheld it. In 1984 Congress passed Section 1031(a)(3) to place some time limits and procedural requirements on non-simultaneous like-kind exchanges, and in 1991 the IRS promulgated regulations that fleshed out the statutory requirements, and provided a safe harbor for "Starker-like" exchanges. If all the rules are followed (and there are a lot of rules), then the basis in the exchange property is transferred to the new property, and no gain is recognized. Consider the following possibilities for using this tool:

• Delaying Recognition of Gain for a Year. A failed or incomplete exchange can still be of some tax benefit if it is begun late in the year and then fails, either because no replacement properties are identified, or because they are not acquired. So long as the taxpayer evidences a bona fide intent to carry out a non-simultaneous exchange, then if an exchange is commenced in one tax year and "falls out" the next year, gain is recognized in the year it fails, not the year it commences. This gives the taxpayer an extra year to pay the tax.
   
  
• Diversification of Investment Portfolio. A single property may be exchanged for a number of replacement properties. This works especially well for an asset with a lot of equity, but not much additional potential for appreciation. Selling that asset and buying a number of lower-cost properties spreads out risk and may yield a higher return (both as current income and in the form of future appreciation) than keeping it all in one asset. This technique can also be used as part of a "lifetime gifting" program to reduce the size of the taxable estate. Either equity can be pulled out by refinancing and giving it away, or (after a suitable holding period) the properties can be placed into one or more entities, and shares of the entities can be given to children and grandchildren.
   
  
• Retiring Farmers. A family farm usually consists of both business property and residential property. It can be subdivided and sold separately-up to $500,000 of profit on the residential part qualifies for non-recognition of gain under another Code section, and the business part can be put into an exchange.
   
  
• Alternative to Installment Sale. Section 1031 can be used to gain more control over when gain is recognized than in a typical installment sale situation. Unless prepayment is prohibited, a payoff on an installment sale could come at a bad time for the taxpayer. With an exchange, one large property can be converted into several less expensive properties, which, after an appropriate holding period, may be liquidated at the convenience of the taxpayer. The income on the replacement properties could be as good as, if not better than, interest received on an installment note.
   
  
• Using Exchange Fund to Improve Replacement Property. Improved property can be exchanged for vacant land, but an exchange can also be set up in such a way that improvements are constructed with the exchange funds. In one case the taxpayer exchanged an apartment house for a vacant tract of land. The qualified intermediary was used to: (a) acquire the relinquished property from the taxpayer, (b) transfer the relinquished property to the purchaser in exchange for cash, (c) acquire the replacement property with some of the exchange proceeds, (d) use the rest of the funds in the exchange account to construct a golf course, and (e) transfer the newly-completed golf course to the taxpayer (within 180 days after the sale of the relinquished property). In a less complex version of this, the seller can make the improvements prior to closing on the replacement property. The contract price will reflect the "as-built" value. The money can be given to the seller out of the exchange account, as non-refundable earnest money, or, if the intermediary has authority to invest exchange funds, it can be lent to the seller and secured by a deed of trust on the property.
   
  
• "Like Kind" Properties that Don't Look Alike. A lease of real property with 30 years or more left to run is exchangeable for a fee interest in real property. Optional renewal periods are included in the calculation of the years remaining in the lease term. A "perpetual scenic conservation easement," or an agricultural conservation easement, if it is classified as real property under state law, can be exchanged for a fee simple interest in real estate that is timberland, a ranch, or a farm. The reversionary interest in property subject to a 99 year lease can be exchanged for property that is not subject to a lease. Similarly, an indefeasibly vested remainder interest in real property can be exchanged for a fee simple interest.

Once the basics are mastered, 1031 Exchanges can be used to further financial and personal goals in addition to deferral of capital gains taxes. Readers are cautioned, however, to use competent tax advisors and legal counsel to structure and carry out their exchanges. There is no flexibility in the "safe harbors" constructed by the IRS, and even minor or unintentional errors can be expensive.