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DOES THE SUBJECT PROPERTY QUALIFY FOR AN I.R.C. § 1031 TAX-DEFERRED EXCHANGE?

If a property owner is going to sell property knowing s/he will be using the proceeds to buy similar or "like-kind" property, it may be advantageous for her/him to complete an I.R.C. § 1031 tax-deferred exchange. Although a taxpayer can utilize I.R.C. § 1031 to exchange both personal property (i.e. airplanes, tractors, cattle) and real property held for productive use in a trade or business or for investment, this discussion, for obvious reasons, will focus only on real property exchanges. As the name implies, a tax-deferred exchange is not a tax free one. However, a properly executed tax-deferred exchange allows the taxpayer to defer the payment of federal income taxes (capital gains) if he sells qualifying property and reinvests the proceeds from the sale into another qualifying like-kind property. The tax would not be due unless and until the taxpayer, subsequent to acquiring the exchanged property, sells the exchanged property outright ("cashes out") rather than reinvesting the sales proceeds into another like-kind property.

On the other hand, the tax would not be due at all if the taxpayer dies owning Replacement Property acquired through a § 1031 exchange. I.R.C. § 1014 directs that upon the death of the taxpayer all property in the decedent's estate is entitled to a stepped-up "basis" for the purpose of calculating the heirs' capital gain upon a subsequent sale. Under this Section of Internal Revenue Code, property is valued as of the date of the decedent's death for purposes of determining its "basis", without regard to when the property was originally acquired or its original basis. Thus, an heir can avoid the tax liability of all capital gains produced during the decedent's lifetime. In order to obtain the tax-deferred benefits § 1031 offers, both the Relinquished Property (the property the taxpayer sells in the exchange) and the Replacement Property (the property the taxpayer acquires in the exchange) must be qualifying property and of likekind. The "like-kind" requirement, when referring to real property exchanges, is very easy for the taxpayer to meet given the extremely broad scope of real property exchanges. Basically, all real property located within the United States is like-kind to all other real property located in the United States. (Real property located in the United States and real property located outside of the United States are not property of like-kind.) Some common examples of like-kind real property exchanges include:

  1. Unimproved real property for improved real property and vice versa;
  2. A commercial building for 3 bare lots and vice versa;
  3. City real estate for agricultural/ranch real estate and vice versa;
  4. A tenancy in common interest for a fee and vice versa;
  5. An easement interest for a fee interest and vice versa; and
  6. Farmland for a tenancy in common interest (TICs), classified as a regulated "D" security
    under the SEC Act of 1933.
The "qualified purpose" requirement is met if the exchange property is (1) held for productive use in the taxpayer's trade or business or if it is (2) held by the taxpayer as an investment. This type of property may be exchanged by the taxpayer for property to be held for either of these two uses. Personal residences, vacation homes, property held as inventory and primarily for sale ("dealer property"), and real property that has been subject to the "more than incidental" personal use of the taxpayer are, therefore, ineligible for § 1031 exchange purposes.

Simple examples of property held for productive use in the taxpayer's trade or business include productive farmland owned by a farmer or corporate office buildings owned by a corporation. Real property "held by the taxpayer for investment" is not defined in the Regulations. However, the Regulations do provide that unproductive real estate held by a "non-dealer" taxpayer for future use and future appreciation is property held for investment. A minimal amount of incidental personal use by the taxpayer will not taint otherwise qualifying investment property.

It is elementary that real property held for productive use in the taxpayer's trade or business may be exchanged for property that will be held by the taxpayer as an investment and vice-versa (i.e. farmland used as part of a farmers business exchanged for 2 bare lots in a growing residential subdivision held for future use and appreciation). It is irrelevant to the legitimacy of an exchange the use to which the non-exchanging party to the transaction places on the Relinquished Property or Replacement Property. Only the taxpayer's purpose for holding both the Relinquished Property and Replacement Property is essential to the validity of an exchange. Whether property is held for a qualified purpose by the taxpayer is a question of fact and such qualified purpose is determined at the time the exchange takes place. The taxpayer bares the burden of proof regarding the qualified purpose issue.

The Regulations do not specify a holding period requirement for either the Relinquished or Replacement Property. The I.R.S., though, has repeatedly taken the position that if a taxpayer acquired the Relinquished Property just prior to an exchange, or if the taxpayer disposes of the Replacement Property soon after an exchange, the taxpayer acquired the property primarily for sale of that property, rather than to hold it for productive use in a trade or business or as an investment. Based primarily upon one I.R.S. private letter ruling, the § 1031 industry generally follows a minimum two-year holding period as being a sufficient amount of time to establish the qualified purpose for both the Relinquished and Replacement Property. The holding period, however, is but one consideration the courts will use in order to determine the intent of the taxpayer regarding property disposed of or acquired in an exchange. It is possible for a taxpayer to exchange personal use real property that does not immediately qualify for § 1031 tax-deferred treatment by converting it to qualifying property. For example, the owner of a vacation home may desire to sell the vacation home as Relinquished Property in an exchange. At present, however, the taxpayer's primary purpose for holding the property is for his personal use and enjoyment of the premises. In order to qualify the property for purposes of § 1031, the taxpayer must abandon the personal use of the real property and thereafter convert it to qualifying investment property by holding it for rental income and/or appreciation. In such a scenario, the taxpayer would be wise to follow the generally accepted two-year minimum holding period in order to better establish the qualified purpose requirement for this Relinquished Property.

"Mixed bag" also called "mixed use" real property is property which is subject to both the personal use and qualifying use of the taxpayer and may, nevertheless, qualify for § 1031 tax-deferred treatment. For example, a taxpayer may own a four-plex property and occupy one of the units as his personal residence while renting out the remaining three units. The taxpayer desires to sell the entire fourplex but would also like to use the four-plex as Relinquished Property in a § 1031 exchange. As long as the taxpayer is able to make a "reasonable allocation" of value between the two types of properties, a § 1031 exchange may be initiated using this property as Relinquished Property. The allocation of value can be based upon the number of units, the respective square footage, the quality of interior improvements, or an appraisal, but any reasonable allocation is permissible. That portion of the property subject to the personal use of the taxpayer would quite obviously not be eligible for § 1031 tax-deferred treatment (but may be subject to Section 121's gain exclusion on the sale of personal residences) and the money generated from its sale should not be included as the taxpayer's exchange proceeds. For all intents and purposes, the taxpayer must treat the transaction as two separate transactions. It is recommended that separate settlement statements be generated for each allocated property or that each allocated portion be specifically and clearly separated in one settlement statement in order to establish that the's personal residence has been excluded from the § 1031 exchange.

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