Understanding Tax-Free Real Estate Exchanges

W. Patrick Scott Esquire
December 20, 2007 — 1,445 views  
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The Internal Revenue Code's new exchange rules provide significant financial incentives for real estate investors

Tax-free real estate exchanges are important tools for investors looking to sell a property, and reinvest in other real estate. The advantage of exchanges is that they allow taxpayers to sell income, investment or business property and replace it with like-kind property without having to pay Federal income taxes on the transaction. The transaction must be a true exchange; the sale of property and subsequent purchase of a replacement property is not legal.

With the issuance of the 1991 regulations (I.R.C. §1031), tax-deferred exchanges became easier, affordable and safer than ever before. Benefits include:

  • Increased cash flow,
  • Additional tax deductions,
  • The chance to rebuild equity when current properties fail to appreciate,
  • The chance to sell properties with problem tenants, etc., and
  • Reinvestment opportunities without taxes on the gain.

How It Works
First, let's examine the meaning of "exchange." The rule states that no gain or loss is recognized on the exchange of property held for productive use if such property is exchanged solely for property of like kind, which is to be held for either productive use in a trade or business. In other words, the law recognizes the tax-free transfer of one property for another.

An exchange is a transfer of property for property. "Relinquished property" is that property sold by a taxpayer, and "replacement property" is the property that is received. Please note that it is not a "rollover" of funds, as in former §1034 (i.e. sell residential real property, take funds and within two years purchase another residential property).

To determine whether there is a "sale and reinvestment" or an exchange, you must consider if the taxpayer ever constructively received possession of the sale proceeds of the relinquished property. It need not be simultaneous. There are numerous ways to structure the transaction through a third party, or "qualified intermediary." This avoids agency problems.

Defining Like-Kind Property

To determine if two properties are "like-kind," examine the nature and character of property, not its grade or quality. Consider these rules:

  • Real property is not like-kind to personal property.
  • What is "property" is determined with respect to state law.
  • Exchange improved real estate for unimproved real estate – but not land for building and bricks next to the property.
  • Multiple replacement properties are permitted as long as they each meet like-kind test.

    With personal property, the property must be the same (trucks for trucks, computers for computers, etc.). The property cannot be inventory because inventory is intended to be resold. 

Defining Productive Use
In addition to being like-kind, the properties must be "held in productive
use for trade or business." Consider these rules:

  • "Use in trade or business" or for investment excludes residences. See I.R.C. §121 (new in 1997), which permits exclusion of up to $250,000 of gain in sale of residence.
  • Regulations specifically provide that "unproductive real estate held by a non-dealer for future use appreciation, is held for investment." Watch, however, for property acquired with the intention to resell it (i.e. subdivision).
  • As for a holding period, there are no regulations or time limits on how long property must be "held." The real question is the taxpayer's intent at the time he or she held the property.

Real Estate Partnerships
The IRS code prohibits the tax-free exchange of partnership interests. Routinely, a partnership holds property and some partners want to "cash out" and others want to continue the investment. This does not mean that partnerships can't exchange.

What happens if a partnership engages in an exchange of real property, then distributes the replacement property to one partner, cash to others? There is risk involved with this transaction. Consider the case of Maloney v. Commissioner, which held that a §1031 exchange may be preceded or followed by a tax-free event. Courts will look to "continuity of investment." Therefore, if property can be distributed by a liquidating partnership tax-free, that partner who never received funds but exchanged it, is entitled to exchange. The risk is that the IRS could take the position that it is a step-transaction and violates the no partnership exchange rule.

MacElree Harvey
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West Chester, PA 19381–0660
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W. Patrick Scott Esquire

MacElree Harvey