Knowing I am a tax attorney, a friend of mine has written to me seeking guidance on a real estate transaction. Here is the message:
“You have a real estate holding that you’re looking to dispose of, and you have gained that will be taxed unless you reinvest it into another real estate holding within six months. Due to time constraints, you decide to invest in a Delaware Statutory Trust (DST) that holds real estate. DSTs are like off-the-shelf investments that qualify as real estate investments. I’d like to know if you need an intermediary or escrow during this transition period, what practical diligence is needed, and which types of properties qualify or don’t qualify for DST investments. Additionally, I’m curious about the current popularity and viability of DSTs.”
The question encompasses understanding how to effectively utilize a Delaware Statutory Trust (DST) in a 1031 tax-deferred exchange, including the process, pros and cons, necessary diligence, and the types of properties that qualify for §1031 transactions. It also seeks clarity on whether an intermediary or escrow is needed during the transition. Since this §1031 transaction is very complicated, we have divided it into two parts: the §1031 transaction and the transaction using DSTs.
Code § 1001(a) outlines the method for calculating realized gain or loss from the sale or disposition of property. Generally, you must recognize this gain or loss, as stated in § 1001(c). However, there’s an important exception known as § 1031, which allows for non-recognition of gain in certain exchanges. The Tax Cuts and Jobs Act of 2017 restricted § 1031 to exchanges involving real property, which had already been the primary use of this provision. Nevertheless, there’s an exception to this restriction.
Understanding Code §1031: Deferring Gain or Loss on Like-Kind Property Exchanges
Code §1031 allows taxpayers to defer recognition of gain or loss on the exchange of property held for productive use in a trade or business or for investment if the exchanged property is of like kind and will also be held for productive use in a trade or business or for investment. This provision aims to support legitimate exchanges by providing taxpayers with the option to defer taxes and avoid the immediate need for cash to pay taxes on gains. It also addresses the administrative challenge of valuing the received property accurately.
Importantly, Code §1031 does not impose any dollar limitations, offering flexibility to taxpayers engaged in like-kind exchanges.
In a mixed like-kind exchange, as outlined in Code §1031(b), gain is only recognized to the extent of cash or non-1031 property received, commonly known as “Boot.” However, §1031(d) sets forth a formula to allocate the total basis between 1031 property and non-1031 property, with non-1031 property assigned a basis equal to its fair market value (FMV).
However, there is an exception noted in Section 1031(a)(2), which states that real property primarily held for sale does not qualify for nonrecognition treatment. This exception has been in place since the original 1921 legislation, meaning that property primarily intended for sale does not enjoy the tax deferral benefits provided by §1031 exchanges.
Understanding Like-Kind Property in §1031 Exchanges: Property Nature, Qualifications, and Case Studies
The term “like-kind” in §1031 refers to the nature or character of property, not its grade or quality (Reg. §1.1031(a)-1(b)). Real property, whether improved or unimproved, qualifies for §1031 exchanges. For instance, exchanging city real estate for a ranch, a 30-year leasehold for real estate, or improved for unimproved real estate all meet the like-kind criteria (Reg. §1.1031(a)-1(c)).
Illustratively, Reg. 1.1031(a)–1(c) confirms that exchanging city improved real estate for a ranch qualifies as a like-kind exchange. Additionally, Rev. Ruling 73–476 states that exchanging a fee simple for a ½ interest in other property of equal value also meets the like-kind definition.
The Bogler Case underscores the importance of holding acquired property for investment or use in a trade or business for §1031 qualification. However, a rapid sale to a corporation may raise concerns, although leniency exists when the taxpayer owns the corporation and intends to conduct business through it.
Reg. 1.1031(a)–2 lists personal property that qualifies for like-kind status, with narrower requirements compared to real property.
In Peabody Natural Resources Company v. Commissioner, supply contracts associated with exchanged mines were deemed like-kind property, not boot. Conversely, in Wiechens v. U.S., limited water rights exchanged for farmland did not qualify as like-kind under §1031, highlighting specific nuances in property categorization.
Lastly, May Dep’t Stores Co. v. Commissioner emphasized the distinction between leaseholds and fee interests in like-kind exchanges, underlining the importance of property type in §1031 qualification.
Requirements and Safe Harbors for Property Identification and Receipt in Code §1031 Exchanges
1031(a)(3) mandates that the taxpayer must simultaneously identify replacement property within 45 days of transferring the relinquished property and receive the replacement property within 180 days after the transfer or by the due date (including extensions) of the taxpayer’s tax return for the year of the transfer, whichever comes earlier.
The regulations for deferred exchanges stipulate that a clear and unambiguous designation of “replacement property” must be made and delivered within the 45-day “identification period.” Contingencies are accounted for, allowing the taxpayer to identify alternate property under the “3-property rule,” “200-percent rule,” or “95-percent rule.” These rules permit the identification of three replacement properties of any value (3-property rule, FMV includes mortgage) or any number of replacement properties not exceeding twice the value of the relinquished property (200-percent rule, FMV includes encumbered mortgage). If the taxpayer identifies too much property, they will be treated as if they identified no property, losing the benefit of §1031 nonrecognition.
The taxpayer can qualify for §1031 treatment if they receive “identified replacement property with a fair market value of at least 95 percent of the aggregate fair market value of all identified replacement property (the ’95-percent rule,’ FMV not including encumbered mortgage).” Refer to Reg. §1.1031(k)-1(c)(4)(ii)(B) for more details.
According to the regulations, replacement property must be received within the “exchange period,” which is the period specified in §1031(a)(3)(B), not exceeding 180 days. (See §1.1031(k)-1(d)(1)). For the “substantially the same property” test, real property produced need not be completed before the date it is received. However, it will be considered substantially the same property as identified only if, had production been completed by that date, it would have been considered substantially the same property as identified (Reg. §1.1031(k)-1(e)(3)(iii)).
Furthermore, the regulations offer “safe harbors” allowing taxpayers to use security or guarantee arrangements, qualified escrow accounts, qualified intermediaries, and interest and growth factors as part of deferred exchanges. You can find more information in Reg. §1.1031(k)-1(g).
Understanding Continuity of Interest in Taxation and Property Exchanges
In tax terms, an exchange often mirrors cashing out an investment in the exchanged property. However, under §1031, real property obtained in a like-kind exchange is seen as a continuation of the initial investment in a modified form. This view considers the investment as ongoing, leading to a technical, but not actual, recognition of gain or loss. As a result, taxing or permitting deductions during the exchange is deemed inappropriate.
Sale vs. Exchange:
Former Regulation §1.1002-1(d) defines an exchange as a reciprocal transfer of property, distinguishing it from a simple transfer for monetary consideration only.
Sale and Leaseback Considerations:
If a lease, with optional extensions, lasts 30 years or more, both the leasehold and fee interest are treated as like-kind properties under Reg. §1.1031(a)-1(c).
Loss Allowance:
Loss is not allowed if the lease has a capital value, meaning it’s worth more than the rent. However, if there’s no capital value, such as when the sale is at full value and the lease is at fair rental with no capital value, a loss on the sale can be permitted.
Understanding Holding Requirements in Section 1031 Exchanges
Section 1031(a) sets forth the requirement that real property involved in an exchange must be “held for productive use in a trade or business or for investment,” both for the relinquished property and the replacement property. This criterion differs from the language used in other sections like §§1221(a)(2) and 1231, which mention “property used in a trade or business.”
The statute explicitly excludes personal-use property from §1031 eligibility. For instance, swapping a rental residential property for another residential property to serve as the taxpayer’s personal residence doesn’t meet the “to be held” requirement. To provide clarity, Revenue Procedure 2008-16 establishes a safe harbor for determining if a dwelling unit qualifies as property held for productive use in a trade or business or for investment under §1031.
Moreover, the application of §1031 to one party in an exchange is independent of its application to other parties involved. Regulations specify that exchanging trade or business property for investment property, or vice versa, may qualify for nonrecognition if the properties are otherwise like kind.
Holding Period Requirement: 2-Year Holding Period
An amendment in 1989 added a 2-year holding period for exchanges between related persons under §1031(f) and (g). Failure to meet these holding requirements results in the recognition of gain or loss in the year of the subsequent disqualifying transfer.
Congress introduced §1031(f)(4) to prevent exchanges designed to bypass the purposes of §1031(f), particularly concerns about related persons attempting to circumvent the rules. Refer to Rev. Rul. 2002-83 for further guidance on this matter.
Exploring Three-Way Exchanges, Round-Robin Exchanges, and Reverse Starker Exchanges in §1031 Transactions
Three-Way Exchanges and Deferred Exchanges
Under certain circumstances, three-way exchanges or deferred exchanges can qualify for §1031 treatment.
Three-Way Exchange:
A wants to exchange with C’s farmland, but C is not interested in A’s property.
B offers to purchase A’s ranch for cash.
A proposes that B purchase C’s farm and then exchange that farm for A’s ranch. B agrees.
Such a three-way exchange can qualify for §1031 treatment, as confirmed by Rev. Rul. 77-297.
Round-Robin Exchange:
A, B, and C engage in a round-robin exchange where A transfers her ranch to B, B transfers real property to C, and C transfers the farm to A.
Each party in this exchange can qualify for §1031 treatment if they satisfy the holding requirements, as per Rev. Rul. 57-244.
It’s not necessary to receive like-kind property from the same person to whom one has transferred property.
However, receiving cash for one’s property, even if reinvested immediately in like-kind property, disqualifies the transaction from §1031 treatment.
Considerations for Potential Problems:
If B cannot or will not take title to C’s property, A can use an accommodator (qualified intermediary) to facilitate the exchange:
The accommodator acquires C’s farm using B’s money.
The farm is then transferred to A, and A’s ranch is transferred to B.
This arrangement is governed by Regulation §1.1031(b)-2.
The “qualified intermediary” safe harbor
The “qualified intermediary” safe harbor is the most crucial among these safe harbors. It allows a taxpayer to engage a person or entity (not a “disqualified person” per §1.1031(k)-1(k)) to acquire and transfer properties without being considered the taxpayer’s agent under §1031. In the scenario involving A, B, and C, if B refuses to purchase and transfer property to A, A can hire an intermediary to sell A’s ranch to B, use the proceeds to acquire the property designated by A (here, C’s farm), and transfer C’s farm to A. This safe harbor enables an agent of A to sell A’s ranch to B for cash without affecting §1031 treatment for A.
Regulation §1.1031(k)-1(g)(4)(iii)(B) mandates that the intermediary acts as a true conduit by acquiring and transferring both the relinquished property and the replacement property. However, direct deeding is allowed, allowing the intermediary to remain outside the chain of title. See Reg. §1.1031(k)-1(g)(4)(iv), (v) for more details.
Reverse Starker Exchanges
Reverse Starker exchanges refer to exchanges where the replacement property is acquired before the relinquished property is transferred. Here’s how it typically works:
The taxpayer arranges for an accommodating party to purchase the property, while the taxpayer identifies which of his parcels of business or investment real estate he will relinquish in an exchange. This arrangement with the accommodating party is often termed a “parking arrangement.”
Once the taxpayer has identified the property to be relinquished, he sets in motion a plan whereby he will ultimately exchange the relinquished property for the commercial real estate being held by the accommodating party.
As part of the transaction, the taxpayer’s relinquished property will be sold by the accommodating party, and the sale proceeds will be used to repay the accommodating party.
Revenue Procedure 2000-37 provides a safe harbor for reverse Starker arrangements like the one described above, qualifying for §1031 treatment if specific requirements are met.
Tax Consequences:
Solely” for Like-Kind Property—Recognition of Gain with Boot
In §1031 exchanges, if a party receives cash or nonqualifying property alongside like-kind property, it’s no longer considered a transaction solely involving like-kind property. While §1031 allows such exchanges, it mandates recognizing gain on the like-kind property up to the amount of boot received (without exceeding the realized gain). Notably, loss recognition on like-kind property is prohibited under these circumstances.
The rules of §1031 specifically pertain to gain or loss associated with the like-kind property involved in the transaction. Any gain or loss related to non-like-kind property is addressed under §1001(c) and is recognized accordingly. Losses stemming from the exchange of nonqualifying property are also recognized within this framework.
Treatment of Liabilities in §1031 Exchanges: Net Liability Relief as Money Received
In §1031 exchanges, relief from liabilities is considered money received by the taxpayer who is relieved of the liability. This type of relief is categorized as boot, a term used to describe non-like-kind property received in an exchange. However, according to regulations like Reg. §1.1031(b)-1(c) and Reg. §1.1031(d)-2, only the net liability relief, which is reduced by any cash paid, is recognized as money received.
Two fundamental rules emerge regarding the treatment of liabilities in §1031 exchanges:
Cash received always counts as “money received.”
Net liability relief, after deducting any cash paid, is also considered “money received” for the purposes of §1031 exchanges.
Basis allocation:
Basis is first allocated to boot and boot basis is its FMV, preserving in the like-kind property the unrecognized gain or loss.
Basis for Non-Like-Kind Property (Boot):
Non-like-kind property, also known as boot, receives a fair market value (FMV) basis in the recipient’s hands.
Basis is initially allocated to the non-like-kind property to the extent of its FMV. This preserves unrecognized gain or loss in the like-kind property, aligning with the general rule of §1031(a).
Basis for Like-Kind Property (Calculation) under §1031(d):
1) Unrecognized gain or loss is preserved by using as a starting point the total bases of all the properties given up.
2) This “substituted basis” (see §7701(a)(42)) is adjusted up or down for gain or loss recognized on the transaction (loss may be recognized when nonqualifying property is exchanged), and is also decreased by “money received.”
(a) liability relief is treated as money received decreasing basis;
(b) liabilities assumed on are treated as money paid (money paid) increases basis.
It may be somewhat confusing to see that, for basis computation purposes, the regulations increase basis by total labilities taken on and by total cash paid, then decrease basis by total liability relief and by total cash received. By contrast, in determining “money received” for gain recognition purposes, it was only the net liability relief (reduced by any cash paid) not the total liability relief, that counted.
Reason? When money is received, or liability relief occurs, or loss is recognized, the taxpayer is in effect receiving a partial return of investment, and it is appropriate to reduce basis to reflect that fact. When money is paid, or liabilities are taken on, or gain is recognized, the taxpayer is in effect increasing investment, and it is appropriate to increase basis as a result.
Interface of Sections 121 and 1031
Exchanges Qualifying for Both Section 121 and Section 1031 Treatment
Under Section 121, taxpayers can exclude gain from the sale or exchange of a principal residence if certain conditions are met. This exclusion applies even if the property is held for business or investment purposes at the time of sale. Here are some key points regarding the interaction of Sections 121 and 1031:
Section 121 should be applied first to any gain realized before applying Section 1031.
Gain attributable to depreciation deductions claimed after May 6, 1997, for the business or investment portion of a residence is not eligible for the Section 121 exclusion. However, Section 1031 may still apply to such gain.
When applying Section 1031, any cash or non-like-kind property (boot) received in exchange for the relinquished business property is considered only to the extent that it exceeds the gain excluded under Section 121.
The basis of the replacement business property received in the exchange is adjusted under Section 1031 to account for any gain excluded under Section 121. This means that any gain excluded under Section 121 is treated as recognized gain for basis calculation purposes under Section 1031.
Section 121(d)(10) — Property Acquired in a Like-Kind Exchange
An important amendment to Section 121 in 2004 stipulates that if property is acquired through a like-kind exchange, it must be held for a minimum of five years before any gain from its sale or exchange can qualify for exclusion under Section 121. This provision imposes a specific holding period requirement for such exchanged properties to be eligible for the Section 121 exclusion.
Disclaimer: The article titled “THE § 1031 TRANSACTION AND THE TRANSACTION USING DSTS” is provided for informational purposes only. It is not intended as legal advice, and you should not rely on it for making legal decisions or taking legal actions. For specific legal advice and representation regarding § 1031 transactions or transactions using DSTs, please contact our attorneys. Our legal team will provide you with personalized guidance and representation tailored to your unique circumstances.
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Cynthia Wu is the Founder and Managing Partner of a law firm, with a strong legal background encompassing complex business litigation, probate, and guardianship cases. She holds a Juris Doctor degree from the University of Arizona and an LLM in Taxation from the University of Florida. Cynthia's experience spans estate planning, probate, and business litigation, and she is admitted to practice law in California, the District of Columbia, Texas, and Florida, as well as before the U.S. Tax Court and the Chinese National Bar.
The § 1031 transaction and DSTs –Part 1
By Cynthia Wu
Knowing I am a tax attorney, a friend of mine has written to me seeking guidance on a real estate transaction. Here is the message:
“You have a real estate holding that you’re looking to dispose of, and you have gained that will be taxed unless you reinvest it into another real estate holding within six months. Due to time constraints, you decide to invest in a Delaware Statutory Trust (DST) that holds real estate. DSTs are like off-the-shelf investments that qualify as real estate investments. I’d like to know if you need an intermediary or escrow during this transition period, what practical diligence is needed, and which types of properties qualify or don’t qualify for DST investments. Additionally, I’m curious about the current popularity and viability of DSTs.”
The question encompasses understanding how to effectively utilize a Delaware Statutory Trust (DST) in a 1031 tax-deferred exchange, including the process, pros and cons, necessary diligence, and the types of properties that qualify for §1031 transactions. It also seeks clarity on whether an intermediary or escrow is needed during the transition. Since this §1031 transaction is very complicated, we have divided it into two parts: the §1031 transaction and the transaction using DSTs.
Code § 1001(a) outlines the method for calculating realized gain or loss from the sale or disposition of property. Generally, you must recognize this gain or loss, as stated in § 1001(c). However, there’s an important exception known as § 1031, which allows for non-recognition of gain in certain exchanges. The Tax Cuts and Jobs Act of 2017 restricted § 1031 to exchanges involving real property, which had already been the primary use of this provision. Nevertheless, there’s an exception to this restriction.
Understanding Code §1031: Deferring Gain or Loss on Like-Kind Property Exchanges
Code §1031 allows taxpayers to defer recognition of gain or loss on the exchange of property held for productive use in a trade or business or for investment if the exchanged property is of like kind and will also be held for productive use in a trade or business or for investment. This provision aims to support legitimate exchanges by providing taxpayers with the option to defer taxes and avoid the immediate need for cash to pay taxes on gains. It also addresses the administrative challenge of valuing the received property accurately.
Importantly, Code §1031 does not impose any dollar limitations, offering flexibility to taxpayers engaged in like-kind exchanges.
In a mixed like-kind exchange, as outlined in Code §1031(b), gain is only recognized to the extent of cash or non-1031 property received, commonly known as “Boot.” However, §1031(d) sets forth a formula to allocate the total basis between 1031 property and non-1031 property, with non-1031 property assigned a basis equal to its fair market value (FMV).
However, there is an exception noted in Section 1031(a)(2), which states that real property primarily held for sale does not qualify for nonrecognition treatment. This exception has been in place since the original 1921 legislation, meaning that property primarily intended for sale does not enjoy the tax deferral benefits provided by §1031 exchanges.
Understanding Like-Kind Property in §1031 Exchanges: Property Nature, Qualifications, and Case Studies
The term “like-kind” in §1031 refers to the nature or character of property, not its grade or quality (Reg. §1.1031(a)-1(b)). Real property, whether improved or unimproved, qualifies for §1031 exchanges. For instance, exchanging city real estate for a ranch, a 30-year leasehold for real estate, or improved for unimproved real estate all meet the like-kind criteria (Reg. §1.1031(a)-1(c)).
Illustratively, Reg. 1.1031(a)–1(c) confirms that exchanging city improved real estate for a ranch qualifies as a like-kind exchange. Additionally, Rev. Ruling 73–476 states that exchanging a fee simple for a ½ interest in other property of equal value also meets the like-kind definition.
The Bogler Case underscores the importance of holding acquired property for investment or use in a trade or business for §1031 qualification. However, a rapid sale to a corporation may raise concerns, although leniency exists when the taxpayer owns the corporation and intends to conduct business through it.
Reg. 1.1031(a)–2 lists personal property that qualifies for like-kind status, with narrower requirements compared to real property.
In Peabody Natural Resources Company v. Commissioner, supply contracts associated with exchanged mines were deemed like-kind property, not boot. Conversely, in Wiechens v. U.S., limited water rights exchanged for farmland did not qualify as like-kind under §1031, highlighting specific nuances in property categorization.
Lastly, May Dep’t Stores Co. v. Commissioner emphasized the distinction between leaseholds and fee interests in like-kind exchanges, underlining the importance of property type in §1031 qualification.
Requirements and Safe Harbors for Property Identification and Receipt in Code §1031 Exchanges
The regulations for deferred exchanges stipulate that a clear and unambiguous designation of “replacement property” must be made and delivered within the 45-day “identification period.” Contingencies are accounted for, allowing the taxpayer to identify alternate property under the “3-property rule,” “200-percent rule,” or “95-percent rule.” These rules permit the identification of three replacement properties of any value (3-property rule, FMV includes mortgage) or any number of replacement properties not exceeding twice the value of the relinquished property (200-percent rule, FMV includes encumbered mortgage). If the taxpayer identifies too much property, they will be treated as if they identified no property, losing the benefit of §1031 nonrecognition.
The taxpayer can qualify for §1031 treatment if they receive “identified replacement property with a fair market value of at least 95 percent of the aggregate fair market value of all identified replacement property (the ’95-percent rule,’ FMV not including encumbered mortgage).” Refer to Reg. §1.1031(k)-1(c)(4)(ii)(B) for more details.
According to the regulations, replacement property must be received within the “exchange period,” which is the period specified in §1031(a)(3)(B), not exceeding 180 days. (See §1.1031(k)-1(d)(1)). For the “substantially the same property” test, real property produced need not be completed before the date it is received. However, it will be considered substantially the same property as identified only if, had production been completed by that date, it would have been considered substantially the same property as identified (Reg. §1.1031(k)-1(e)(3)(iii)).
Furthermore, the regulations offer “safe harbors” allowing taxpayers to use security or guarantee arrangements, qualified escrow accounts, qualified intermediaries, and interest and growth factors as part of deferred exchanges. You can find more information in Reg. §1.1031(k)-1(g).
Understanding Continuity of Interest in Taxation and Property Exchanges
In tax terms, an exchange often mirrors cashing out an investment in the exchanged property. However, under §1031, real property obtained in a like-kind exchange is seen as a continuation of the initial investment in a modified form. This view considers the investment as ongoing, leading to a technical, but not actual, recognition of gain or loss. As a result, taxing or permitting deductions during the exchange is deemed inappropriate.
Sale vs. Exchange:
Former Regulation §1.1002-1(d) defines an exchange as a reciprocal transfer of property, distinguishing it from a simple transfer for monetary consideration only.
Sale and Leaseback Considerations:
If a lease, with optional extensions, lasts 30 years or more, both the leasehold and fee interest are treated as like-kind properties under Reg. §1.1031(a)-1(c).
Loss Allowance:
Loss is not allowed if the lease has a capital value, meaning it’s worth more than the rent. However, if there’s no capital value, such as when the sale is at full value and the lease is at fair rental with no capital value, a loss on the sale can be permitted.
Understanding Holding Requirements in Section 1031 Exchanges
Section 1031(a) sets forth the requirement that real property involved in an exchange must be “held for productive use in a trade or business or for investment,” both for the relinquished property and the replacement property. This criterion differs from the language used in other sections like §§1221(a)(2) and 1231, which mention “property used in a trade or business.”
The statute explicitly excludes personal-use property from §1031 eligibility. For instance, swapping a rental residential property for another residential property to serve as the taxpayer’s personal residence doesn’t meet the “to be held” requirement. To provide clarity, Revenue Procedure 2008-16 establishes a safe harbor for determining if a dwelling unit qualifies as property held for productive use in a trade or business or for investment under §1031.
Moreover, the application of §1031 to one party in an exchange is independent of its application to other parties involved. Regulations specify that exchanging trade or business property for investment property, or vice versa, may qualify for nonrecognition if the properties are otherwise like kind.
Holding Period Requirement: 2-Year Holding Period
An amendment in 1989 added a 2-year holding period for exchanges between related persons under §1031(f) and (g). Failure to meet these holding requirements results in the recognition of gain or loss in the year of the subsequent disqualifying transfer.
Congress introduced §1031(f)(4) to prevent exchanges designed to bypass the purposes of §1031(f), particularly concerns about related persons attempting to circumvent the rules. Refer to Rev. Rul. 2002-83 for further guidance on this matter.
Exploring Three-Way Exchanges, Round-Robin Exchanges, and Reverse Starker Exchanges in §1031 Transactions
Under certain circumstances, three-way exchanges or deferred exchanges can qualify for §1031 treatment.
Three-Way Exchange:
Such a three-way exchange can qualify for §1031 treatment, as confirmed by Rev. Rul. 77-297.
A, B, and C engage in a round-robin exchange where A transfers her ranch to B, B transfers real property to C, and C transfers the farm to A.
Each party in this exchange can qualify for §1031 treatment if they satisfy the holding requirements, as per Rev. Rul. 57-244.
It’s not necessary to receive like-kind property from the same person to whom one has transferred property.
However, receiving cash for one’s property, even if reinvested immediately in like-kind property, disqualifies the transaction from §1031 treatment.
Considerations for Potential Problems:
If B cannot or will not take title to C’s property, A can use an accommodator (qualified intermediary) to facilitate the exchange:
The accommodator acquires C’s farm using B’s money.
The farm is then transferred to A, and A’s ranch is transferred to B.
This arrangement is governed by Regulation §1.1031(b)-2.
The “qualified intermediary” safe harbor
The “qualified intermediary” safe harbor is the most crucial among these safe harbors. It allows a taxpayer to engage a person or entity (not a “disqualified person” per §1.1031(k)-1(k)) to acquire and transfer properties without being considered the taxpayer’s agent under §1031. In the scenario involving A, B, and C, if B refuses to purchase and transfer property to A, A can hire an intermediary to sell A’s ranch to B, use the proceeds to acquire the property designated by A (here, C’s farm), and transfer C’s farm to A. This safe harbor enables an agent of A to sell A’s ranch to B for cash without affecting §1031 treatment for A.
Regulation §1.1031(k)-1(g)(4)(iii)(B) mandates that the intermediary acts as a true conduit by acquiring and transferring both the relinquished property and the replacement property. However, direct deeding is allowed, allowing the intermediary to remain outside the chain of title. See Reg. §1.1031(k)-1(g)(4)(iv), (v) for more details.
Reverse Starker exchanges refer to exchanges where the replacement property is acquired before the relinquished property is transferred. Here’s how it typically works:
Revenue Procedure 2000-37 provides a safe harbor for reverse Starker arrangements like the one described above, qualifying for §1031 treatment if specific requirements are met.
Tax Consequences:
Solely” for Like-Kind Property—Recognition of Gain with Boot
In §1031 exchanges, if a party receives cash or nonqualifying property alongside like-kind property, it’s no longer considered a transaction solely involving like-kind property. While §1031 allows such exchanges, it mandates recognizing gain on the like-kind property up to the amount of boot received (without exceeding the realized gain). Notably, loss recognition on like-kind property is prohibited under these circumstances.
The rules of §1031 specifically pertain to gain or loss associated with the like-kind property involved in the transaction. Any gain or loss related to non-like-kind property is addressed under §1001(c) and is recognized accordingly. Losses stemming from the exchange of nonqualifying property are also recognized within this framework.
Treatment of Liabilities in §1031 Exchanges: Net Liability Relief as Money Received
In §1031 exchanges, relief from liabilities is considered money received by the taxpayer who is relieved of the liability. This type of relief is categorized as boot, a term used to describe non-like-kind property received in an exchange. However, according to regulations like Reg. §1.1031(b)-1(c) and Reg. §1.1031(d)-2, only the net liability relief, which is reduced by any cash paid, is recognized as money received.
Two fundamental rules emerge regarding the treatment of liabilities in §1031 exchanges:
Cash received always counts as “money received.”
Net liability relief, after deducting any cash paid, is also considered “money received” for the purposes of §1031 exchanges.
Basis allocation:
Basis is first allocated to boot and boot basis is its FMV, preserving in the like-kind property the unrecognized gain or loss.
Basis for Non-Like-Kind Property (Boot):
Non-like-kind property, also known as boot, receives a fair market value (FMV) basis in the recipient’s hands.
Basis is initially allocated to the non-like-kind property to the extent of its FMV. This preserves unrecognized gain or loss in the like-kind property, aligning with the general rule of §1031(a).
Basis for Like-Kind Property (Calculation) under §1031(d):
1) Unrecognized gain or loss is preserved by using as a starting point the total bases of all the properties given up.
2) This “substituted basis” (see §7701(a)(42)) is adjusted up or down for gain or loss recognized on the transaction (loss may be recognized when nonqualifying property is exchanged), and is also decreased by “money received.”
(a) liability relief is treated as money received decreasing basis;
(b) liabilities assumed on are treated as money paid (money paid) increases basis.
It may be somewhat confusing to see that, for basis computation purposes, the regulations increase basis by total labilities taken on and by total cash paid, then decrease basis by total liability relief and by total cash received. By contrast, in determining “money received” for gain recognition purposes, it was only the net liability relief (reduced by any cash paid) not the total liability relief, that counted.
Reason? When money is received, or liability relief occurs, or loss is recognized, the taxpayer is in effect receiving a partial return of investment, and it is appropriate to reduce basis to reflect that fact. When money is paid, or liabilities are taken on, or gain is recognized, the taxpayer is in effect increasing investment, and it is appropriate to increase basis as a result.
Interface of Sections 121 and 1031
Exchanges Qualifying for Both Section 121 and Section 1031 Treatment
Under Section 121, taxpayers can exclude gain from the sale or exchange of a principal residence if certain conditions are met. This exclusion applies even if the property is held for business or investment purposes at the time of sale. Here are some key points regarding the interaction of Sections 121 and 1031:
Section 121(d)(10) — Property Acquired in a Like-Kind Exchange
An important amendment to Section 121 in 2004 stipulates that if property is acquired through a like-kind exchange, it must be held for a minimum of five years before any gain from its sale or exchange can qualify for exclusion under Section 121. This provision imposes a specific holding period requirement for such exchanged properties to be eligible for the Section 121 exclusion.
Disclaimer: The article titled “THE § 1031 TRANSACTION AND THE TRANSACTION USING DSTS” is provided for informational purposes only. It is not intended as legal advice, and you should not rely on it for making legal decisions or taking legal actions. For specific legal advice and representation regarding § 1031 transactions or transactions using DSTs, please contact our attorneys. Our legal team will provide you with personalized guidance and representation tailored to your unique circumstances.