Internal Revenue Code

Common Questions About 1031 Exchanges & "Flipped" Property

Internal Revenue Service

Real estate investors have a lot of questions when it comes to 1031 exchanges and flipped property. In this article, we’re going to discuss some of the IRS regulations surrounding this topic.

According to the IRS

According to the instructions for IRS form 8824, Section 1031 doesn't apply to exchanges of real property held “primarily for sale,” so flip properties probably don’t fit the definition of “held for productive use in a trade or business or for investment.” 

See also IRS PUB 544 which states: “the nonrecognition rules for like-kind exchanges apply only to exchanges of real property not held primarily for sale.

 26 U.S. Code § 1031.Exchange of real property held for productive use or investment

(a) Nonrecognition of gain or loss from exchanges solely in kind

(1) In general

No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for realproperty of like kind which is to be held either for productive use in a trade or business or for investment.

But

1031 (a)(2) says that:

(2) Exception for real property held for sale

This subsection shall not apply to any exchange of real property held primarily for sale.

Commercial Partners Exchange in Minneapolis, MN

Exchanging property under section 1031 can be a complicated process, but we are here to help! The qualified intermediaries at Commercial Partners Exchange Company have over two decades of experience helping clients through 1031 exchanges. If you want to save money in capital gains taxes when selling investment property, a like-kind exchange may be right for you. Give us a call today to learn more about our 1031 exchange services and how we can help you through the 1031 exchange process.

  • Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

 

© 2019 Copyright Jeffrey R. Peterson All Rights Reserved

Will 1031 Exchanges Ever go Away?

1031 exchange future

Some people are really worried that section 1031 will be eliminated by congress in the next major tax overhaul. This article will go over a brief history of 1031 exchanges, and what the future looks like for tax-deferred exchanges.

A Brief History of IRC Changes

The United States has had various iterations of the Internal Revenue Code and some major overhauls. The last overhaul happened in 1986, and guess what happened to the values of real estate after the ‘86 tax reform? They went down, and they stayed down for quite a while because Congress was insensitive to the plight of the real estate investor. The shock from the tax changes really hurt real estate values.

My hope is that in the future Congress will be more surgical and sympathetic to the needs of real estate investors and will incorporate section 1031 into the next overhaul. But the play that congress will have to entertain is that they will eliminate all of these many loopholes and incentives in order to gain the simplicity of lowering overall tax rates.

What Would Happen if 1031 Exchanges Went Away

There is however an illusion about section 1031’s elimination. People estimate that eliminating section 1031 would be a revenue raiser by eliminating the tax deferral. However the reality is if you eliminate 1031, all of the velocity you feel in the market will cease to continue. Another way of saying that is, a farmer or apartment building owner will simply stay in their property. They won’t want to sell it and take the tax hit on the sale, so they just stay in the property. With 1031 they could go into a bigger and better property.

1031 exchanges have been really HOT for the last 24 months. This has been a HUGE force that has helped to power-up the U.S. economy.  When private capital can move tax-free to the most advantageous like-kind investments it drives development, job growth, and boosts private-sector productivity and efficiency. 

Eliminating 1031 would not raise any additional revenue, but would slow deal velocity to a halt.  Investors would rather stay locked-in to their tired old properties rather than pay unnecessary taxes on a sale and risk a move-up to a bigger property.

  • 1031 Hotline: If you have questions about changes to the IRC, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

 

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

What is a 1033 Exchange?

1033 exchanges

There are two cousins in the Internal Revenue Code. There’s Section 1031 for voluntary sales, and section 1033 for involuntary sales (i.e. condemnations, requisitions, seizure or losses that may occur through theft, destruction or an act of god).

1033 Involuntary Sales

1033 is the provision for the involuntary sale or loss and it’s actually more favorable to the taxpayer than 1031. In 1033 you don’t need to hire a qualified intermediary. You can hold onto your own proceeds. And you’re not limited to 180 days to complete your exchange – you have 2 years (in certain circumstances that can even be extended to a 3 year period).

Like-Kind & 1033

The like-kind requirement in 1031 is a little more flexible and loose than that for 1033. Generally under 1033 the replacement property must be “similar or related in service or use,” which is a more stringent standard than under 1031. There’s a case where under section 1033 a taxpayer disposed of a bowling alley and replaced it with a billiards parlor.* The IRS said that was not like-kind enough and the exchange failed. So 1033 is perhaps more complex when it comes to the like-kind standard.

Try 1033 First

I would always try to exhaust the 1033 option first because of the longer time frame and the fact that you don’t need a QI. You do however need to file for the election on your tax return to take advantage of the 1033.

Here’s the deal though – 1033 exchanges are rare occurrences. You have to be subject to a threat of condemnation or have suffered an involuntary loss. And many municipalities are gun-shy of litigation and would rather work out a voluntary sale, rather than bring out the big guns and take a condemnation action. I would say that 99% of exchanges are 1031s because voluntary sales are much more frequent than involuntary sales.

  • 1031 Hotline: If you have questions about 1033 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

 

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

*In Rev. Rul. 76-319, 1976-2 C.B. 242, the owner of a recreational bowling center that was destroyed by fire, attempted to replace the property with a recreational billiard center. It was determined that bowling alleys and bowling equipment were insufficiently similar to billiard tables and billiard equipment for the billiard center to qualify as property similar or related in use to the converted bowling center. Similarly in Rev. Rul. 76-390, 1976-2 C.B. 243, it was determined that the physical characteristics and end uses of a motel were insufficiently similar to those of a mobile home park for the motel to qualify as property similar or related in service or use.

1031 Exchanges Between Family Members

1031 exchange between family members

Generally, related party 1031 transactions should be avoided, especially as to the purchases of replacement property. We'll explain why in this article.

Would a Taxpayer be Able to 1031 into a Piece of Land Owned by His or Her Daughter?

Internal Revenue Code (“IRC”) Section 1031 (f) has special rules for exchanges between related persons that may require the related parties to hold their respective properties for two years after an exchange. However 1031 (f) also contains a killer clause that the related party exchange cannot be part of a transaction structured to “avoid” the imposition of tax. It’s hard to discern a compelling differentiation between the intention to legally and indefinitely defer one’s taxes and an impermissible intention to avoid the imposition of tax. The IRS has picked up on this and has successfully fought some heart-breaking cases. The result is that there are a string of unfriendly tax court cases and rulings that have really muddied the waters for related party purchases.  In one case a son purchased his replacement property from his mother…and the IRS disallowed the 1031 exchange.

“Related Person”

The term “related person” means any person bearing a relationship to the taxpayer described in section IRC Sections 267 (b) or 707 (b)(1) and can broadly include family members and people you are in business relationships with (such as a partnership, corporation or trust). To make matters more complicated, because of the IRS’s rules of attribution, a person may be considered to be a related person even if you wouldn’t normally consider them a related to you.

The problem for farmers who want to buy adjoining land, and families with closely located properties that they know and understand, is that these desirable replacement properties may be owned by related parties, such as an uncle, mother or brother.

  • 1031 Hotline: If you have questions about 1031 exchanges between family members, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

 

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved