South Carolina Lawyer
Vol. 13, No. 2, Pg. 38.
Tax-deferred exchanges under Section1031 IRC
38Tax-deferred exchanges under §1031 IRCBy Derrick M. TharpeUnder 1031 of the Internal Revenue Code, a taxpayer May exchange property currently held for investment or productive use in a trade or business for similar or like kind property. If the exchange of property is consistent with the provisions of 5 1031, the taxpayer will receive a deferral of the capital gains tax associated with the transfer. The legislative rationale for tax-deferred exchanges is that the exchange of an asset for a similar asset of equal or greater value represents a continuity of investment that should not be taxed at the time of the exchange.
The initiative for a tax-deterred exchange was set forth in 1921 (IRC §202 (c); IRC 5 1001; 1RC 1031), and although it established the initial framework for the conduct of an exchange, these regulations left mam issues unresolved. Scc Slorkrr Commis-4mo , 602 F.2d 1341 (901 Cir. 197(1); Estate of Power, c. Conum,,loncl , 582 (1990); , 733 E2d 14() (9th GI. 1990). However, as a result of the landmark legal decision in Starker v. Commissioner (Starker v. Commissioner, 602 [2d 1341 (9th Cir. 117(1), basic guidelines were established that made exchange opportunities much more practical for the taxpayer. Ihrough the Tax Reform Act of 1984 and 1991 Treasury Department Regulations rules were adopted that define the current structure of §1031 exchanges. IRC § 1031; Treas. Reg. 1.1031.
40 "Held for" requirement
To determine the viability of a § 1031 exchange transaction, the taxpayer must first determine whether the properties to be exchanged will meet the qualified purpose requirement of § 1031. Pursuant to § 1031(a)(2), property will not be eligible for non-recognition treatment unless it is held by the taxpayer for use in a trade or business, or for investment.
However, neither § 1031 nor the regulations define the terms "held for productive use in trade or business" or "held for investment." Therefore, the determination as to whether the property is held for a qualified purpose is a question of fact (See Gulf Stream Land & Development Corp., 71 TC 587 (1979)) and is to be determined at the time the exchange takes place. Klarkowski v. Comm., TC Memo 1965-328, aff'd 385 F.2d 398 (CA7 1967). Thus, the prior or subsequent use of either the relinquished or replacement property in the hands of another party is immaterial to the exchange.
It should also be noted that the taxpayer has the burden of proof in establishing that the property has been held for a qualified purpose. Land Dynamics v. Comm., TC Memo 1978-259. Although not determinative, the amount of time that the property has been held by the taxpayer is an important consideration in evaluating whether the exchange property meets the qualified purpose requirement. While there is no specific holding period for the relinquished or replacement property, the longer the property has been held the more likely the taxpayer will be able show the requisite purpose. See Ltr Rul 8429039; the IRS has stated that a 2 year holding period would be sufficient holding period for the qualified use test.
The like-kind requirement
Under § 1031, the property the taxpayer intends to exchange must be like kind to the replacement property the taxpayer plans to acquire. In the context of a tax-deferred exchange, "like kind" refers to the nature or character of the property, not its grade or quality. Treas. Reg. 1.1031(a)-1(b).
The regulations further provide that both real property and personal property may be exchanged. However, the distinction as to whether the property to be exchanged is real or personal property is critical, as real property is not like-kind to personal property. Rev Rul 59-229, 1959-2 CB 180; Oregon Lumber Co. v. Comm., 20 TC 192 (1953). Additionally, the definition of like kind is much more restrictive for personal property transactions.
Generally, the determination as to whether the property to be exchanged is either real or personal property is based upon the law of the state in which the property is located. Aquilino v. U.S., 363 U.S. 509 (1960); Coupe v. Commissioner, 52 T.C. 394 (1969). The Regulations do make specific reference to a 30 year lease as real property, Treas. Reg. 1.1031 (a)-1(c)(2), and remaining option periods under the lease are to be considered in calculating the 30 year term of the lease. Century Electric Co. v. Commissioner, 192 F. 2d 155 (8th Cir. 1951).
Regarding the exchange of real property (or real estate), the regulations are extremely broad and provide that, as a general rule, all real property is like kind as to all other real property. For example, improved real property is like kind with raw land (Treas. Reg. 1.1031(a)-1(b)) and an apar intent complex is like kind with a retail shopping center. Thus, like kind is not defined by the value of the real estate to be exchanged; it is established by the underlying character of the property.
Although many tax professionals are familiar with...