The basic elements of a deferred exchange under Section 1031 are (1) a qualified relinquished property; (2) a qualified “like-kind” replacement property; (3) a qualified replacement property owner; (4) replacement property of equal or higher market value than the relinquished property; (5) no real or constructive receipt of the proceeds; and (6) strict adherence to the time limits for identifying and closing on replacement property.
Every one of these elements is necessary for a valid Section 1031 exchange. If any one of these elements fails, the IRS will not recognize the transaction as a Section 1031 exchange but as a sale and you will be required to pay capital gains taxes.
What is a Qualified Relinquished Property?
You must begin with ownership of a tangible property that is qualified for an exchange under Section 1031.
There are really two requirements here.
First, what is being exchanged must be tangible property. Second, both the relinquished property and the replacement property must be “held for productive use in a trade or business, or for investment.”
You can only exchange tangible property for tangible property. Section 1031 applies only to “the exchange of property. . . for property.”
In other words, in order to qualify for the tax benefits of an exchange under Section 1031, what is being exchanged must be ownership of tangible property (such as land, buildings, mineral deposits, or uncut timber), not a security (such as stocks and bonds),services, or a lease or rental interest.
The property requirement also raises questions regarding the forms of property ownership. There are several ways to own property. The most obvious way to own property is by sole and unrestricted ownership.
Sole ownership means that you are the only person who owns all of the interest in a piece of property.
In sole ownership, with the exception of some legal restraints such as maintaining a public nuisance, zoning restrictions, infringing on the rights of others, and the possible interests of a surviving spouse, you may do whatever you wish with your property, both during your lifetime and, through a will, even after your death. Sole owners can sell, exchange, mortgage, give away, or will their property however they choose.
In addition to sole ownership, there are also several ways to own real property in co-ownership with others. Co-ownership of property exists when two or more persons (or business entities) hold title to the same property.
The most important forms of co-ownership of real property are joint tenancy and tenancy-in-common. Both joint tenancy and tenancy-in-common involve what is called an undivided interest in the property. An undivided interest in real property means that each co-owner owns a proportional share (sometimes called a “fractional” interest) of the total value of the property.
Co-ownership of an undivided interest in real property means that one co-owner cannot claim the more valuable part of a property while asserting that the other co-owners possess only the less valuable parts. Instead, each co-owner owns a proportional share of the entire property.
In a joint tenancy, two or more persons (or business entities) own undivided interests in the same property with what is called a “right of survivorship.” This means that if one joint tenant dies, the property belongs solely to the surviving joint tenants, not to any possible heirs or beneficiaries of the deceased co-tenant, since property owned by joint tenancy cannot be transferred by a will.
Because of the right of survivorship, joint tenancy is most commonly used in family situations; that is, between husband and wife, parents and children, or grandparent and grandchild. Common examples of joint tenancy are a bank account in your name and your spouse’s name, a certificate of deposit with your name and the name of one of your children, and a government bond with your name and the name of a relative such as a husband, wife, child, or grandchild.
In theory, the primary advantage of ownership of property by joint tenancy is that probate is avoided or minimized, the property passes immediately and automatically to the surviving joint tenants. In addition, because property that is owned by joint tenancy passes immediately and automatically to the surviving joint tenants, it is protected against any claims by the deceased joint tenant’s creditors.
Among the primary disadvantages of owning property by joint tenancy are that it prevents the property from passing through inheritance to your heirs and beneficiaries, it lacks the flexibility to adapt to new circumstances such as divorce or remarriage, and serious problems can arise if one joint tenant sells or wants to sell a piece of property and the other tenants did not want it sold.
In addition, although joint tenancy is often used as an estate planning tool (in order to transfer property while avoiding probate and shielding property from creditors), it usually results in undesirable tax consequences when the property is eventually sold because the surviving joint tenants have received only a partially stepped-up basis.
Moreover, if there is a joint tenant who is not your spouse, the entire value of the property would be included in the taxable estate of the first tenant to die unless the other tenants could prove that they contributed to its purchase.
For all these reasons, ownership by joint tenancy is not favored for investment property or any property that is not co-owned only by close family members.
In a tenancy-in-common, two or more persons (or business entities) own undivided interests in the same property without any right of survivorship. This means that each of the tenants-in-common has the right to sell, exchange, mortgage, give away, or, unlike joint tenants, transfer by will his or her proportional share of the property.
In contrast to joint tenancy, the tax consequences of inheriting tenancy-in-common property are straightforward and predictable; the inheriting person gets a full step-up in basis on that portion of the property.
A potential disadvantage of ownership by tenancy-in-common is that the property passes to the estate of any deceased tenant-in-common, and so is subject to probate, estate taxes, and the claims of the deceased tenant-in-common’s creditors.
For this reason, property that is to be co-owned by close family relations whom you are absolutely certain you want to inherit your property at your death are sometimes better held in a joint tenancy. On the other hand, property owners can exchange a single large property through a Section 1031 for several smaller properties, and thus, divide their estate so that it can be bequeathed relatively easily to their heirs.
The advantages of a tenancy-in-common are numerous.
Investment in a property held as a tenancy-in-common can typically provide a larger and more stable investment than the same monetary investment in property held as either sole ownership or joint tenancy.
Tenancies-in-common also provide greater ease 0f investment and lower acquisition risk than joint tenancies and sole ownership.
Perhaps most importantly for real estate investors who are contemplating a Section 1031 exchange, suitable tenancies-in-common are often easier to identify and acquire within the exchange statute’s strict time limitations than other properties.
All environmental reports, title work, and other background research has already been done by a sponsor, preventing surprises and resultant delays – or worse – such as title problems, inspection delays, toxic waste issues, or boundary disputes, any of which can hold up escrow and potentially be fatal to a Section 1031 exchange.
Significantly, owning property through a tenancy-in-common can maximize the benefits of real property ownership while providing relief from many of its most troublesome headaches and uncertainties.
Because tenancies-in-common are typically managed by professional management companies, you will no longer have to deal with the problems of collecting rent, avoiding vacancies, negotiating leases, demands for repairs and other tenant complaints, or with delinquencies and evictions. You will also have the freedom to live wherever you want – or at least take a vacation – without having to worry about the maintenance and management of your real estate investment.
Common examples of real property owned by tenancy-in-common are multi-family residential properties, hotels, large single tenant retail properties, multi-tenant business parks and malls, and leased office buildings. In fact, any relatively stable income-producing property that qualifies as a “like-kind” exchange under Section 1031 can be owned as a tenancy-in-common.
Leases or rental interests do not qualify for a Section 1031 exchange because they are not considered to constitute property ownership.
There is, however, one important exception to this rule. The IRS has ruled that a lease for 30 years or longer is a qualifying property interest under Section 1031.
Land leases for 30 years or longer are most common in geographic areas like New York, Boston, Chicago, and other high density cities where available land for new development is scarce and where a specific parcel might not be able for sale, but is available for lease.
Such long term land leases are also used by the government to lease land that cannot be sold. Under most 30-year or longer leases, the tenant constructs an improvement for the tenant’s own long-term use. The receipt of prepaid lease payments, whether for a 30-year lease or not, are taxed as ordinary income and will not qualify for tax-free exchange treatment.
Co-ownership interests in real property, such as joint tenancy and tenancy-in-common, must be sharply distinguished from partnership interests in real property.
The Internal Revenue Code specifically excludes partnership interests from the tax-free exchange provisions of Section 1031. If either the relinquished property or the replacement property is determined by the IRS to be a partnership interest, the transaction will not qualify as an exchange under Section 1031.
The IRS’s rationale for this exclusion is that a partnership interest, unlike a joint tenancy or a tenancy-in-common, is not direct ownership of real property, and therefore is not qualified “like-kind” property under Section 1031. As the IRS sees it, an interest in a partnership that owns real property is an interest in the partnership, not in the property. A partnership interest is a personal property interest (like stocks, bonds, and other securities) and not “like-kind”with real property.
The exclusion of partnership interests from the exchange provisions of Section 1031 applies to all forms of partnership, including both limited and general partnerships, and applies regardless of what kind of assets are owned by the partnership.
For example, an interest in a partnership that owns an office building or a farm is excluded from the tax-free exchange provisions of Section 1031, despite the fact that the underlying assets owned by the partnership are real property. For this same reason, shares in a real estate investment trust (REIT) are excluded from the tax-free exchange provisions of Section 1031 despite the fact that the underlying assets owned by the trust are real property.
Since partnership interests are excluded from the tax-free exchange provisions of Section 1031, you might ask whether real property held by partnerships can be exchanged under Section 1031. The answer is “Yes.”
Partnerships, just like individuals or corporations, can exchange property as the taxpayer under Section 1031 and avoid capital gains taxes and recapture of depreciation. For example, if a partnership owns an office building, the partnership can exchange that office building under Section 1031 for another office building, or an apartment complex, or any other qualified “like-kind” property.
The partnership, like any other taxpayer, will not have to pay capital gains taxes or depreciation recapture as a result of this exchange of like-kind property. It cannot, however, exchange a share of the partnership itself.
There are occasions when it makes financial sense to split up or liquidate a partnership and exchange the real property assets held by the partnership to take advantage of the tax avoidance benefits of Section 1031. For example, the partners may have developed divergent goals or simply no longer get along well together. Or the partners may want to sell the partnership property, but each partner wants to do with his share of the proceeds as he pleases.
In such cases, there are two basic strategies: drop and swap and swap and drop.
In a drop and swap transaction, a partnership first distributes assets to the partner(s) who want to cash out of the partnership (the drop), and then these partners exchange the assets, as individual owners, under Section 1031 (the swap).
The partnership can be liquidated and the partnership’s entire real property assets distributed individually to each partner. Or, rather than liquidate the entire partnership, one or more of the partners can opt out of the partnership and receive some of the partnership’s real property assets, either as sole owners or as holders of an undivided interest in co-tenancy with the partnership.
In a swap and drop transaction, the partnership first exchanges the property under Section 1031 (the swap), and then distributes the replacement property to he individual partners (the drop).
Although the sharp distinction between interests in partnerships (which are excluded from tax-free exchange under Section 1031) and fractional co-ownership of real property as joint tenants or tenants-in-common (which are qualified “like-kind” property) must be kept in mind, the line between a partnership interest and fractional co-ownership interest is sometimes more fine than bright.
Unfortunately, neither the statute, the Internal Revenue Code, the IRS, nor the courts have provided certainty in this area. For this reason, it is critically important that you consult with your attorney and your tax advisor before entering into a Section 1031 exchange involving property that could conceivably be considered a partnership interest.
For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.
To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to email@example.com
For Part Two of this article, click here.
For Part Three of this article, click here.