IRS Scrutiny of Section 1031 Exchanges
The Replacement Deadlines
Qualified Replacement Property
The Merits of a Section 1031 Exchange

IRS Scrutiny of Section 1031 Exchanges

The Treasury Inspector General has issued a critique of potential abuses associated with the popular Section 1031 tax deferred exchange technique. This review suggested that the IRS should be increasing its enforcement of possible abuses and errors on real estate exchanges. The Treasury Release noted that Section1031 exchanges have become increasingly popular, and with this activity there are indications that some exchanges are being conducted improperly. So, on the premise that we are moving toward increased IRS scrutiny, here are some points to consider:

Section 1031 exchanges are designed to allow a business or investor to dispose of one property and replace it with another without incurring current taxation. The gain on the original property is not eliminated, but simply defers into the replacement asset. Thus, Section1031 exchanges are not a tax elimination technique, but rather a tax deferral strategy.

Most exchanges today are done with the use of an independent party known as a qualified intermediary (QI). The QI closes the sale of the relinquished property for the taxpayer, and holds the cash awaiting directions on reinvesting the sale proceeds in one or more replacement properties. The use of a QI allows a deferred exchange: The exchanger’s property is disposed of, but that taxpayer is allowed a period of time to reinvest the sales proceeds to complete the exchange. However, there are some rigid deadlines that must be met.

The Replacement Deadlines

One of the concerns identified in the recent Treasury release was noncompliance with the two deadlines associated with a deferred exchange conducted through a QI. When a seller moves property to a QI to start the exchange process, two deadlines begin ticking. The first is a 45-day identification period. Within that timeframe, the seller must identify one or more replacement properties that are under consideration to complete the exchange. This is simply a written notification to the QI, but it is an absolute requirement to accomplish a successful 1031 exchange.

Qualified Replacement Property

Section 1031 has liberal rules regarding the definition of “like-kind” real estate for exchange purposes. Improved property containing buildings can be exchanged for unimproved investment or agricultural land, and different categories of property may be exchanged (residential rental for commercial real estate, for example). But the Treasury study suggests that abuses are occurring with taxpayers attempting to stretch this rule to include vacation and other personal use properties.

A recent court case pointed out that a seasonal vacation home, because of its personal use, does not fit the “business or investment” requirement of Section1031. The taxpayer argued that the property had inflated and was an investment, but this was dismissed by the court in view of the taxpayer’s personal use of the lake cabin (Moore, TC Memo 2007-134).

The Merits of a Section 1031 Exchange

Tax deferral, especially for long periods of time, can be very valuable. In fact, if the real estate received in the exchange is held for the taxpayer’s lifetime, the capital gain tax may never be paid. This occurs because property that passes through an estate receives a fresh tax cost equal to its market value. This eliminates the deferred capital gain, and the heirs of the decedent can sell the property without any income tax recognition (assuming the property is sold shortly after the estate before further appreciation occurs).

But in other cases, a Section1031 exchange takes place, and the replacement property might be sold within the near term. In these cases, the gain has only been deferred for a short period, and this raises the question of the wisdom of doing the earlier Section 1031 exchange. An exchange requires fees, and a short term deferral may not be efficient.

Further, today’s capital gain rates are at an all-time low. Some of the leading presidential candidates have indicated that it is their intent to increase the capital gain rate from its present 15%, suggesting rates ranging from 20% to 28%. History tells us that capital gain rates have ebbed and flowed with political changes in Washington. Given the dynamics of the 2008 elections, accomplishing an exchange today that defers a gain to the near future, where higher capital gain rates might apply, may not be advantageous.

If you have any questions concerning the tax issues discussed here, please contact us at info@marg.com.