By Cynthia Wu

As a tax attorney, a friend of mine has reached out for advice on a real estate transaction. Here’s what they asked:

You own real estate and want to avoid taxes on your gains by reinvesting in another property within six months. Due to time constraints, you’re considering a Delaware Statutory Trust (DST), a ready-made real estate investment. Do you need an intermediary or escrow? What diligence is necessary? Which properties qualify for DST investments? How popular and viable are DSTs?

To effectively use a Delaware Statutory Trust (DST) in a 1031 tax-deferred exchange, you must understand the process, pros and cons, diligence needed, and property types qualifying for §1031 transactions. You also need clarity on intermediaries or escrows during the transition. We’ll break this down into two parts: the §1031 transaction and the transaction using DSTs.

Code §1001(a) calculates gains or losses from property sales. Generally, you recognize these, but §1031 defers taxes if you reinvest in similar property in a like-kind exchange. Note: deferred gain isn’t tax-free. The Tax Cuts and Jobs Act of 2017 narrowed §1031 to real property exchanges, with exceptions.

Understanding Code §1031: Deferring Gain or Loss

Code §1031 defers gain or loss recognition on property exchanges for business or investment use if the exchanged property is like-kind and used similarly. This deferral supports exchanges, avoids immediate tax burdens, and eases property valuation challenges.

Moreover, Code §1031 has no dollar limits, offering flexibility.

In mixed exchanges, gain is only recognized for cash or non-1031 property received (“Boot”). Additionally, §1031(d) allocates basis between 1031 and non-1031 property using FMV.

However, §1031(a)(2) excludes property primarily held for sale from nonrecognition treatment, marking an exception since 1921. Consequently, such property doesn’t enjoy §1031’s tax deferral benefits.

One of the administrative challenges lies in accurately valuing received property. Nonetheless, Code §1031 grants flexibility without dollar limitations in like-kind exchanges. In mixed exchanges per Code §1031(b), gain is recognized only for cash or non-1031 property (termed “Boot”). Yet, §1031(d) allocates basis between 1031 and non-1031 property.

Furthermore, an exception in Section 1031(a)(2) denies nonrecognition treatment for real property primarily held for sale since 1921 legislation.

Regarding like-kind in §1031, it pertains to property nature, not quality (Reg. §1.1031(a)-1(b)). This means that real property, improved or not, qualifies. For instance, city real estate for a ranch or leaseholds for real estate meet like-kind criteria (Reg. §1.1031(a)-1(c)).

Regulation 1.1031(a)–1(c) confirms city improved real estate for a ranch as like-kind. Additionally, Rev. Ruling 73–476 states that a fee simple for a ½ interest in equal value qualifies too.

The Bogler Case emphasizes holding acquired property for investment for §1031 qualification. Moreover, Reg. 1.1031(a)–2 lists personal property qualifying for like-kind status.

In Peabody Natural Resources Company v. Commissioner, it was established that supply contracts were like-kind, not boot. Conversely, limited water rights for farmland didn’t qualify in Wiechens v. U.S., illustrating nuances in categorization.

Another case, May Dep’t Stores Co. v. Commissioner, distinguished leaseholds and fee interests, which are vital in §1031 qualification.

Moving on to §1031(a)(3), it mandates simultaneous identification and receipt of replacement property within specified periods. Furthermore, regulations allow identifying alternate property under various rules like the “3-property rule” or “95-percent rule.”

These regulations also offer “safe harbors” like qualified intermediaries and escrow accounts for deferred exchanges (Reg. §1.1031(k)-1(g)).

Understanding Continuity of Interest in Taxation and Property Exchanges

An exchange under §1031 views real property as a continuation of the initial investment in a modified form, thus avoiding gain or loss recognition during the exchange.

Differentiating Between Sale and Exchange:

An exchange involves reciprocal property transfers, which are distinct from a transfer for cash only (Regulation §1.1002-1(d)).

Sale and Leaseback:

Leases with optional 30-year extensions treat leasehold and fee interest as like-kind (Reg. §1.1031(a)-1(c)).

Regarding Loss Allowance:

Loss is disallowed if the lease has capital value but allowed if there’s no capital value, such as in full-value sales with fair rental leases.

Understanding the Holding Requirements in §1031 Exchanges

• 1031(a) requires that exchanged real property must be “held for productive use in a trade or business or for investment.” Personal-use property is ineligible for §1031 treatment.

To determine if a dwelling qualifies under §1031, Revenue Procedure 2008-16 provides a safe harbor.

• 1031 applies independently to parties in an exchange, allowing nonrecognition for exchanges involving trade/business-to-investment properties.

The Holding Period Requirement: 2-Year Holding Period

• 1031(f) and (g) establish a 2-year holding period for related-party exchanges. Failure to meet this requirement leads to recognizing gain or loss in the year of the subsequent disqualifying transfer.

• 1031(f)(4) prevents exchanges designed to bypass rules, addressing concerns about related parties circumventing regulations. Detailed guidance can be found in Rev. Rul. 2002-83.

Exploring Three-Way Exchanges, Round-Robin Exchanges, and Reverse Starker Exchanges in §1031 Transactions

Certain scenarios, such as three-way exchanges or deferred exchanges, can qualify for §1031 treatment:

Three-Way Exchange:

A wants to exchange with C’s farmland, but C isn’t interested.

B offers to buy A’s ranch for cash.

A proposes that B purchase C’s farm, then exchange it for A’s ranch. B agrees.

Such exchanges can qualify under §1031, as per Rev. Rul. 77-297.

Round-Robin Exchange:

A, B, and C engage in a round-robin exchange transferring properties among themselves. Each party can qualify for §1031 treatment if they meet holding requirements, per Rev. Rul. 57-244.

Considerations for Potential Problems:

Using an accommodator (qualified intermediary) can facilitate exchanges, especially if one party can’t or won’t take title to another’s property.

The “qualified intermediary” safe harbor is crucial, allowing an intermediary to acquire and transfer properties without being the taxpayer’s agent under §1031, per Regulation §1.1031(k)-1(g)(4)(iii)(B).

Direct deeding is allowed under Reg. §1.1031(k)-1(g)(4)(iv), (v), enabling the intermediary to stay outside the chain of title while acting as a true conduit.

Reverse Starker Exchanges:

Reverse Starker exchanges involve acquiring replacement property before transferring the relinquished property:

The taxpayer arranges for an accommodating party to purchase the property while identifying which of their parcels of real estate they will relinquish in an exchange—a process often called a “parking arrangement.”

Once the relinquished property is identified, the taxpayer sets a plan in motion to exchange it for the commercial real estate held by the accommodating party.

As part of the transaction, the accommodating party sells the relinquished property, and the proceeds are used to repay them.

Revenue Procedure 2000-37 offers a safe harbor for such reverse Starker arrangements, qualifying for §1031 treatment if specific requirements are met.

Tax Consequences:

The exchange can involve like-kind property exclusively or include cash, liabilities, and non-like-kind property. Cash, relief from debt, or non-like-kind property may trigger taxable gain in the exchange year.

If cash or non-like-kind property is received alongside like-kind property, gain is recognized up to the amount of boot received, without exceeding realized gain.

Treatment of Liabilities in §1031 Exchanges:

Relief from liabilities is treated as money received by the taxpayer, categorized as boot.

Net liability relief, after deducting any cash paid, is considered money received under §1031 exchanges.

Basis Allocation:

Basis is allocated to boot based on its fair market value (FMV), preserving unrecognized gain or loss in like-kind property.

Non-like-kind property (boot) receives an FMV basis in the recipient’s hands.

Basis for like-kind property is calculated using the total bases of properties given up, adjusted for gain or loss recognized, and decreased by money received or increased by money paid.

Understanding the basis computation and money received in §1031 exchanges ensures proper recognition of gain, loss, liabilities, and cash in exchange transactions.

Interface of Sections 121 and 1031:

Exchanges Qualifying for Both Section 121 and Section 1031 Treatment:

Section 121 allows taxpayers to exclude gain from the sale or exchange of a principal residence under specific conditions. This exclusion applies even if the property is held for business or investment purposes at the time of sale. Key points regarding the interaction of Sections 121 and 1031 include:

Apply Section 121 first to any gain realized before applying Section 1031.

Gain from depreciation deductions claimed after May 6, 1997, for the business or investment portion of a residence isn’t eligible for the Section 121 exclusion. However, Section 1031 may still apply to such gain.

When using 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.

Adjust the basis of the replacement business property received in the exchange under Section 1031 to account for any gain excluded under Section 121. This means treating any gain excluded under Section 121 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 states that property acquired through a like-kind exchange 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 exchanged properties to be eligible for the Section 121 exclusion.

Disclaimer:

The information provided is for informational purposes only and not intended as legal advice. For specific legal advice and representation regarding Section 1031 transactions or transactions using DSTs, please contact our attorneys for personalized guidance tailored to your unique circumstances.