Complex Issues
Since 1921, the rules for qualifying and completing 1031 exchanges have gradually broadened and become less restrictive. Still there are do's and don'ts as well as several gray areas of which taxpayers must be aware:
Holding periods
There is no standard or specific holding period that a Taxpayer must abide by (the only exception is Related parties, discussed below). Holding periods are, therefore, determined on a case-by-case basis with regard to the Taxpayer's intentions, based in part by: their reasons for acquiring, holding, and disposing of the property; the Taxpayer's primary occupation; previous 1031 exchange activity; and use of property.
Generally, the longer the holding period the better. However, a Taxpayer who is disqualified from utilizing the benefits of Section 1031 would not then qualify merely because of a long holding period. What the Code, the courts, and the IRS want to prevent primarily is a Taxpayer utilizing Section 1031 to defer taxes on the sale of a property (e.g., a car dealer or a builder of residential subdivisions).
Related parties
Related parties may do exchanges with each other; however, there is a mandatory 24-month holding period for both related parties. Related parties can be business, familial, or ancestral. Should either party dispose of their newly acquired property within the 24-month required holding period, both parties' exchanges will be disallowed. The current rules are complex and restrictive, and all potential "related party" exchangers must seek their own tax counsel.
Different entities
Generally, to qualify for Section 1031 the same entity which transferred the relinquished property must acquire the replacement property.
Already owned property
The "like-kind" requirement will not have been met if the Taxpayer attempts to transfer the gain from the relinquished property into property the Taxpayer already owns.
Refinance
It is generally accepted that the Taxpayer may receive equity from the replacement property through the placement of a loan (refinance). However, the Taxpayer must not refinance "in anticipation" of an exchange by placing a loan on the relinquished property while the taxpayer has taken steps to dispose off such property. This is true unless the Taxpayer:
- uses those proceeds to acquire or improve the replacement property, and
- has no actual or constructive receipt of such proceeds.
Dissolution of a partnership
The Code is clear on this matter. Partnership interests do not qualify for Section 1031 tax deferral. Yet Taxpayers' advisers routinely recommend the following strategy:
- Dissolve partnership.
- Create new entity (tenancy-in-common).
- Distribute pro-rata share to individuals (previously partners).
- Exchange individual tenancy-in-common interests at will.
Two fundamental problems arise from this advice:
- The Code requires that property must be "held for productive use in a trade or business or investment". This implies that there is a holding period, although, as discussed above, the holding period is uncertain.
- If the new structure was construed by the IRS as merely a strategy or series of steps to avoid the exclusion pertaining to partnership interests, the exchange would be disallowed.
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