Real Estate Transactions Under Section 1031 of the Internal Revenue CodeOctober 2011 – Newsletters In the Zone
Section 1031 of the U.S. Internal Revenue Code (26 U.S.C. § 1031) (the Code) sets forth that gains and losses for certain exchanges of property are not recognized. Pursuant to §1031(A)(1) of the Code, in order for a taxpayer to defer capital gains upon the sale of real property, the relinquished property and the replacement property must be held by the exchanger (the holding requirement) for productive use in a trade or business or for investment (the use requirement).
The last volume of the Real Property, Trust and Estate Law Journal (45 Real Prop. Tr. & Est. L.J. 635 (2011)) includes an article by Brant J. Hellwig , a professor at the University of South Carolina School of Law, titled “The Holding Intent Requirement for Property Transferred in a Section 1031 Exchange.” Professor Hellwig’s article notes that inasmuch as the Code does not mandate a duration for the holding requirement, coupled with the Internal Revenue Service’s paradoxical position that the determination of the taxpayer’s intent regarding the property is to be made at the time of exchange, taxpayers and their advisers are forced to rely upon Internal Revenue Service rulings and limited case law for guidance.
Professor Hellwig commences his analysis by examining pertinent IRS rulings, all of which were issued in the 1970s and 80s and that universally concluded the taxpayer in question did not qualify for nonrecognition treatment under §1031. Conversely, the case law Professor Hellwig cites, including two Ninth Circuit Court of Appeals’ affirmations of earlier Tax Court decisions, is generally more favorable to the taxpayer. In Magneson v. Commissioner (81 T.C. 767 (1983), aff’d, 753 F.2d 1490 (9th Cir. 1985), the taxpayer exchanged investment property for like-kind property, then subsequently contributed the replacement property to a general partnership. The Tax Court held this prearranged transfer was a continuation of the previous investment, rather than a liquidation of the investment, thus satisfying the requirements of §1031. Similarly, in Bolker v. Commissioner (760 F.2d 1039 (9th Cir., 1985), aff’g 81 T.C. 782 (1983), the Tax Court cited Magneson in ruling that when property received in a corporation liquidation was exchanged in a prearranged transaction for like-kind property, the holding requirement of §1031 was fulfilled.
Professor Hellwig next focuses on legislative rationale for maintaining nonrecognition treatment under §1031. He concludes that administrative, equitable and market-efficiency considerations all support removing impediments to nonrecognition.
Due to the inherent complexities arising from interpreting Section 1031, taxpayers should always seek professional guidance when contemplating transactions which may fall under this abstract section of the Code. Lawyers in the firm's Real Estate Department work closely with tax lawyers in the firm in advising clients on whether real property interests held by clients may qualify for tax-free exchange treatment.