"IRC Section 1031: Hither and Yon"

Originally published by Matthew Bender; 18 The Real Estate Tax Digest 8, 287 Aug. 2000. 

Thomas R. Popplewell is a tax lawyer and partner of the Dallas office of Houston's Andrews & Kurth. His e-mail address is tpopplewell@akllp.com. The views represented here are his own and do not represent those of the firm.

Copyright 2000, Matthew Bender. All rights reserved.

Section 1031 of the Internal Revenue Code of 1986,1 provides that no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a like kind which is to be held either for productive use in a trade or business or for investment. This provision has been in the Code for a number of years and was amended in 1984 to allow deferred exchanges and in 1989 to restrict exchanges between related persons. Regulations dealing with deferred exchanges were finalized in 1991 and amended in l994.2 Nevertheless, new issues and unanswered questions arise surprisingly often.

Reverse Exchanges

Quite often a taxpayer will want or need to acquire replacement property before disposing of the relinquished property. He may attempt to do this by a “reverse exchange.”3 There are no current authorities that definitively authorize reverse exchanges.4 Taxpayers presently attempt to obtain the desired result through various means, including the use of “parking” arrangements. In a parking arrangement the taxpayer directs an accommodation party to acquire the replacement property, often with funds obtained from or through the taxpayer. When the taxpayer later is prepared to dispose of the relinquished property a three party exchange occurs whereby the accommodation party exchanges the replacement property for the relinquished property and then sells the relinquished property. The principal issue in a parking arrangement is whether the accommodation party owns the replacement property for tax purposes, i.e., whether he has sufficient burdens and benefits of ownership. Clearly, this is a sticky situation because the accommodation party will typically want full indemnification from the taxpayer for all liabilities associated with the replacement property during the time that the accommodation party “owns” it, and only the most benevolent taxpayer will allow the accommodation party to profit during the parking period, particularly at the taxpayer’s ultimate expense. Related issues include (i) management and control of the parked property, (ii) taxpayer guarantees of third party financing of the parked property, (iii) scope of prohibited relationships between the taxpayer and the accommodation party, and (iv) tax reporting mechanics for the parking arrangement. The IRS is considering the issuance of a Revenue Procedure that will reportedly provide safe harbors by which a taxpayer may accomplish a reverse exchange.5

Related Party Exchanges

Section 1031(f)(2) generally provides that if within two years after a “related party” exchange if either related party disposes of the property received in the exchange, gain or loss will be recognized. Generally, if gain is recognized because one of the related parties makes an early disposition, then the gain recognized is taken into account in the taxable year in which the early disposition occurs.6 However, the IRS has held in a Field Service Advice that where a taxpayer attempted to use an unrelated qualified intermediary to accomplish an exchange between related parties and then one of the related parties sold the replacement property within two years of the exchange, section 1031(f)(4) can be applied to cause the gain to be recognized in the year of the original sale. Section 1031(f)(4) provides that if the original exchange is a part of a transaction (or a series of transactions) structured to avoid the related party rules section 1031 does not apply. Thus, the IRS believes that not only will a qualified intermediary not “cleanse” a related party transaction it is considered an avoidance transaction triggering section 1031(f)(4) and thus the original exchange is not subject to section 1031 at all (except, of course, to section 1031(f)(4)).7

Note that section 1031(f)(2)(C) provides that if the IRS determines that neither the exchange nor the disposition had as one of its principal purposes the avoidance of federal income tax, then the early disposition is not taken into account. The related legislative history provides three examples of when this could be shown: “(i) a transaction involving an exchange of undivided interests in different properties that results in each taxpayer holding either the entire interest in a single property or a larger undivided interest in any of such properties; (ii) dispositions of property in nonrecognition transactions; and (iii) transactions that do not involve the shifting of basis between properties.”8 In 1999 the IRS ruled privately that the gain recognition provisions of section 1031(f) did not apply in a situation described in clause (i) above.9 Interestingly, the legislative history does not include in its examples the event of a divorce. Situations can easily be imagined where a taxpayer who had entered into a related party exchange and was divorced within two years thereafter might want to dispose of the affected property for non-tax avoidance purposes.

Note also the related party rules should not apply where a qualified intermediary acquires the relinquished property from the taxpayer, sells it for cash to a related party and then acquires and delivers the replacement property from an unrelated party.

Deferred Exchanges and Early Releases of Funds

In a deferred exchange the funds held by the qualified intermediary will not be treated as constructively received by the taxpayer provided that certain conditions apply. Among these conditions are that the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash held by the qualified intermediary be strictly limited.11 Generally, a taxpayer must have no rights to receive, pledge, borrow, or otherwise obtain the benefits of money before the end of the exchange period unless (i) the taxpayer has not identified replacement property by the end of the identification period or (ii) after the replacement property has been identified, (A) the taxpayer has received all of the replacement property to which he is entitled under the exchange agreement, or (B) the occurrence after the end of the identification period of a material and substantial contingency that (1) relates to the deferred exchange, (2) is provided for in writing, and (3) is beyond the control of the taxpayer and of any “disqualified person,”12 other than the person obligated to transfer the replacement property to the taxpayer.13

Consider the following two situations. (1) The taxpayer identifies three replacement properties with the intent of acquiring all three properties. The aggregate fair market value of the three replacement properties equals the fair market value of the relinquished property. In accordance with the terms of the exchange agreement, the qualified intermediary acquires and transfers two of the properties to the taxpayer. The taxpayer, after negotiating in good faith with the seller of the remaining identified replacement property, is unable to reach an agreement with the seller. The taxpayer thereafter requests that the qualified intermediary distribute to him the remaining cash prior to the end of the exchange period. (2) The taxpayer properly identifies a single replacement property but, after the close of the identification period and after negotiating in good faith with the seller of the identified replacement property, the taxpayer is unable to reach an agreement for the purchase of the property. The taxpayer requests that the qualified intermediary distribute the cash to him before the end of the exchange period. In each of the cases the IRS has ruled privately that the qualified intermediary could not amend its standard contract to allow for the early distribution of the unused cash because neither (i) the requirement of Treas. Reg § 1.1031(k)-1(g)(6)(iii)(A) that the taxpayer has received all the replacement property to which he is entitled nor (ii) the “beyond the control of the taxpayer” requirement of Treas. Reg § 1.1031(k)-1(g)(6)(iii)(B)(3) would be met as to any of the contracts entered into using the amended contract.14 The application of this rationale to situation (2) where only one property is identified defies logic, because the taxpayer is going to recognize all the gain on the relinquished property in any event.

1 Unless otherwise indicated, all section reference are to the Internal Revenue Code of 1986.

2 T. D. 8346, 1991-1 C. B. 150 and T. D. 8535, 1994-1 C.B. 202.

3 The preamble to the regulations dealing with deferred exchanges specifically notes that the regulations do not deal with reverse exchanges. T.D. 8346, 1991-1 C.B. 150.

4 The IRS has permitted reverse exchanges of utility easements in a public works project. See PLR 9823045 (Mar. 10, l998 ) and PLR 9814019 (Dec. 23, 1997).

5 Remarks of Kelly Alton, Senior Technician Reviewer, IRS Office of Assistant Chief Counsel (Income Tax and Accounting), at a meeting of the Sales, Basis and Exchange Committee of the Section of Taxation of the American Bar Association, May 13, 2000. See also Louis Weller, Reverse Exchange Ad Hoc Task Force Report (visited July 15, 2000) www.abanet.org/tax.

6 IRC § 1031(f)(l).

7 FSA 199931002 (Apr. 12, 1999).

8 S. Prt. No. 56, 101st Cong., 1st Sess. 151 (1989).

9 PLR 199926045 (Apr. 2, 1999). An ex-spouse who owned timberland as a cotenant with a related corporation that had acquired the other co-tenancy from her ex-husband’s estate was allowed nonrecognition treatment on an exchange with the corporation. The corporation and the ex-spouse exchanged their respective co-tenancy interests so that she and the corporation each owned 100% of one-half of the timberland acreage. After the exchange, the taxpayer intended to hold her timberland for investment; however, the corporation intended to harvest some of the timber on its land. The harvesting of timber under a section 631 election is treated as a “sale or exchange.”

10 Treas. Reg 1.1031 (k)-1(g)(1).

11Treas. Reg. §§ 1.1031(k)-1(g)(3) and (4).

12As defined in Treas. Reg. § 1.1031(k)-1(k).

13Treas. Reg. § 1.1031(k)-1(g)(6).

14PLR 200027028 (Apr. 10, 2000).