Since 1921, the rules for qualifying and completing 1031 exchanges have gradually broadened and become less restrictive. Even so, there are do’s and don’ts as well as several gray areas of which taxpayers should be aware. The topics below could each be the subject of their own post. They are raised here to draw your attention, and to invite further discussion with your advisors, and the team at Accruit.
Holding periods
There are no standard or specific holding periods by which a taxpayer must abide for property to meet the definition of “like kind” or held for investment or business use (the only exception is Related Parties, discussed below). Holding periods are, therefore, determined on a case-by-case basis regarding the taxpayer’s genuine intentions based in part on: (i) their reasons for acquiring, holding, and disposing of the property; (ii) the taxpayer’s primary occupation; (iii) previous 1031 exchange activity; and (iv) use of property. Generally, the longer the holding period the better. However, a taxpayer who is disqualified from utilizing the benefits of Section 1031 would not then qualify merely because of a long holding period. What the Code, the courts, and the IRS want to prevent is taxpayers holding property primarily for sale and attempting to defer their taxes utilizing Section 1031 (e.g., a builder of residential subdivisions).
Related parties
The current rules are complex and restrictive, and all potential related party exchangers are encouraged to seek the guidance of their tax and legal counsel. Selling a relinquished property to a related party as part of an exchange transaction may be acceptable, provided the related party holds the property for a mandatory 24-month holding period. Acquiring a replacement property from a related party with exchange funds may also be acceptable, if the related party does their own 1031 exchange and holds their replacement property for two years and does not “cash out” of that property. (https://www.buzzsprout.com/270590/5561182″>Listen to Max Hansen discuss the intricacies of related party issues)
Different entities
Generally, to qualify for Section 1031 the same entity that transferred the relinquished property must acquire the replacement property. For example, if the old property is being sold by an LLC, the new property should be acquired by the same LLC. It clearly should not be acquired by another entity, which would be a completely different taxpayer. There are some limited exceptions in the event an LLC is a single-member LLC, and the new property is being acquired by a new LLC with the same single member as the former LLC.
A similar issue arises when spouses are involved in an exchange transaction. For example, if the old property is owned solely by Husband, the new property should not be acquired by Husband and Wife. Conversely, if the old property is owned by Husband and Wife, the new property should be acquired in the same fashion. There are some very narrow exceptions to these rules, which go beyond the scope of this newsletter.
Already owned property
The “like kind” requirement will not have been met if the taxpayer attempts to transfer any exchange value from the relinquished property into property the taxpayer already owns. For example, the taxpayer cannot reinvest the proceeds from the sale of a relinquished property into upgrades at taxpayer’s other property. Further, the proceeds from the relinquished property may not be used to pay down existing debt on taxpayer’s other property.
Refinance
It is generally accepted that the taxpayer can receive equity from the replacement property through the placement of a new loan (refinance). However, the taxpayer must not refinance the old or relinquished property “in anticipation” of an exchange by placing a loan on the relinquished property once the taxpayer has taken steps to dispose of such property unless the taxpayer: 1) uses those proceeds to acquire or improve the replacement property, and 2) has no actual or constructive receipt of such proceeds. It generally helps is there is a bona fide business reason for any refinance within the parameters of an exchange transaction.
Dissolution of a partnership
The Code is clear – partnership interests do not qualify for Section 1031 tax deferral. Yet taxpayers’ advisors routinely recommend the following strategy:
Dissolve partnership.
Create new entity (tenancy-in-common).
Distribute pro-rata share to individuals (previously partners).
Exchange individual tenancy-in-common interests at will.
Two fundamental problems arise from this advice:
1. The Code requires that property must be “held for productive use in a trade or business or investment.” This implies there must be a holding period, for tenancy in common interests distributed out of a partnership although, as discussed above, the holding period requirement is uncertain. (Read more on the release of exchange funds)
Conclusion
If any of these issues is or may be present in your 1031 exchange, it is strongly recommended that you discuss them with your tax and legal advisors, and your qualified intermediary, as soon as possible. Accruit’s leadership team has over 170 years of combined experience in working with taxpayers and their advisors in structuring successful 1031 exchanges.
At Accruit, we handle all types of complex exchanges. Have a situation you’d like to speak to an expert about? No problem. We’re happy to have a free, no-obligation consultation with you.
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