More On Real Estate Exchanges

Overview

My post last fall on what constitutes real estate for purposes of a like-kind exchange under I.R.C. §1031 generated a great deal of interest among readers, lots of good questions and lengthy discussion. https://lawprofessors.typepad.com/agriculturallaw/2018/10/what-is-like-kind-real-estate.html  In light of that, it’s worth expanding the topic a bit to address some rather interesting scenarios that can arise in the context of like-kind exchanges.

That’s the topic of today’s post – a deeper dive on like-kind exchanges.

The Basics

I.R.C. §1031 provides for tax deferred treatment of real property that is exchanged for real property of “like-kind.”  Personal property trades were eligible for tax-deferred treatment before 2018, but now the provision only applies to real estate trades.  Thus, real estate that is used in the taxpayer’s trade or business or held for investment can be “traded” for any other real estate that the taxpayer will hold for use in the taxpayer’s trade or business or for investment.  It’s a broad standard.  For example, eligible real estate can be rental properties; farmland; office buildings; retail real estate properties; storage units; bare land held for investment; golf courses; conservation easements; partial interests in property; water rights (in some states (as pointed out in the prior post); and even vacation homes (if certain requirements are satisfied). In addition, the rules don’t require real property trades to be by type.  Any type of real estate can be traded with any other type.  Treas. Reg. §1.1031(a)-1(b).  What matters is the reason the taxpayer held the relinquished property and the replacement property.  

What About Property That Doesn’t Produce Income?

A permissible reason for trading real estate is to hold the replacement property on the hopes that it will appreciate in value.  Thus, real estate that is held for appreciation purposes without producing income can be traded for other real estate.  The replacement real estate can also be held for value-appreciation purposes.  Basically, this is a favorable tax rules for those that speculate on a tract of real estate appreciating in value.  It also means, for example, that a farmer can defer tax on a trade of farmland that the farmer uses in the farming operation for farmland that is not farmed but used for hunting or fishing purposes, etc.  The farmer is deemed to hold the replacement property for investment purposes.  But, whenever real estate is traded for real estate that will be held for investment purposes, depending on the real estate market, the replacement property should be held long enough to sufficiently illustrate the investment purpose of holding the replacement property.  There is no bright line to determined how long is long enough.

But, there is a distinction to note with respect to property held for investment purposes.  I.R.C. §1031 treatment does not apply to real estate that is held for resale or as inventory.  This is a rule that is of particular importance to land developers and building contractors.  That’s because the real estate that such parties hold constitute inventory.  The same result occurs for a taxpayer that acquires an apartment complex with the intent at the time of the acquisition of selling the complex to current occupants as condominiums.  The IRS views such deals as a “resale” transaction. 

The line between property that is held for investment purposes and property that is held for resale can be rather fine.  For example, what about a taxpayer that buys homes, renovates them and then as soon as the home has been renovated (i.e., updated) list the homes for sale at a profit?  You may have seen the television shows featuring parties that do this.  Rather than being sold, can these homes qualify for I.R.C. §1031 treatment?  It’s not likely.  In these situations, the IRS has a legitimate claim that the homes were acquired and “held” for the intent and purpose of selling them (resale) and not for investment purposes.  To qualify for I.R.C. §1031 treatment at some point in the future, the homes would need to be rented out for a period of time (the longer the better) or be clearly held for appreciation. 

Mixed-Use Real Estate

Quite often, the question arises as to how to handle a like-kind exchange of farmland when a personal residence is involved.  Indeed, I had this question come up at a tax seminar in Missouri earlier this week.  It’s a great question.  Many exchanges of farmland involve more than just bare farmland.  Buildings, structures, and the farm residence may also be involved in the transaction.  As for the personal residence, I.R.C. §121 allows the exclusion of gain of up to $500,000 on a joint return ($250,000 on a single return) if the taxpayer owned the home and used it as the taxpayer’s principal residence for at least two of the immediately previous five years.  If the residence gain can qualify for the I.R.C. §121 exclusion, the residence portion of the real estate should be parceled out from the other real estate that will qualify for a like-kind exchange?  Keeping in mind that an exclusion from income is better from a tax standpoint than is income tax deferral, as much real estate as possible should be included with the residence.  But, how much? The maximum benefit is obtained if enough real estate along with the residence can be combined to “max-out” the $500,000 exclusion. Certainly, land that is adjacent to the residence that is functionally used along with and as part of the residence counts as the “residence” for purposes of the I.R.C. §121 exclusion.  The caselaw is all over the board on this issue.  It’s a very fact-specific issue with the question being how much land can reasonably be claimed to be used along with the residence. For additional guidance on the matter see Rev. Proc. 2005-14, 2005-1 C.B. 528.

From a transactional and practice standpoint, the documents supporting the exchange (known as the “exchange agreement”) should detail only the real estate that qualifies for tax deferral under I.R.C. §1031.  To this end, it may be helpful to include in the documentation a map of the property that distinguishes the property that will be treated as the personal residence for purposes of I.R.C. §121 from the I.R.C. §1031 property with the exchange agreement only listing the I.R.C. §1031 property.  A closing statement can then be utilized for the I.R.C. §121 property, and then a separate statement can be used for the I.R.C. §1031 property.  Indeed, separate closing statements can be used in any transaction involving mixed-use properties – not just when a principal residence is involved. This is of particular importance post-2017 because personal property involved in a trade of real-property no longer qualifies for I.R.C. §1031 treatment.

Also, the IRS position is that property that is used for both business and personal purposes cannot be treated as two separate properties for purposes of the holding requirement – that the property be held for the productive use in a trade or business or for investment.  See, e.g., C.C.A. 201605017 (Jan. 29, 2016).    

Do Vacation Homes Qualify?

The upfront answer is, “no” – a vacation home doesn’t qualify for I.R.C. §1031 treatment.  It’s not qualifying property unless it is held for the right reason – as trade or business property or for investment purposes.  So, while a vacation home wouldn’t normally meet the test, it may be possible to convert the home to a qualified use to eventually allow it to qualify as part of an I.R.C. §1031 exchange.  That can be accomplished by the taxpayer renting the vacation home out and either limiting or eliminating personal use.  For example, in a case involving the exchange of two vacation houses, Moore, et ux. v. Comr., T.C. Memo. 2007-134, the Tax Court determined that the vacation homes at issue failed to qualify for I.R.C. §1031 treatment because the taxpayer failed to prove that they were held for primarily for investment.  Instead, the evidence revealed that the taxpayer basically used the home as a second residence and for personal vacation retreats for family.  The Tax Court also pointed out that the taxpayer did not rent or attempt to rent the properties; didn’t offer the replacement property for sale until forced to do so by liquidity needs; spent a great deal of time fixing up the property; kept a boat at the lake for personal use; didn’t claim any deductions for depreciation or maintenance expenses; claimed home mortgage interest deductions; and failed to maintain the relinquished property during the last two years of ownership (i.e., failed to protect the taxpayer’s investment in the property). 

But, Moore doesn’t stand for the proposition that a vacation home cannot qualify as part of an I.R.C. §1031 transaction.  Under an I.R.S. safe harbor (that was issued after Moore was decided), if the relinquished and/or the replacement property is owned for two years either immediately before or after the exchange; the taxpayer rents out the property at fair market value for 14 days or more during the tax year; and the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period during which the property is rented at fair market rental, the safe harbor applies.  See, Rev. Proc. 2008-16, 2008-1 C.B. 547.  In addition, the safe harbor is just that – a safe harbor.  A transaction involving a vacation home can still qualify under I.R.C. §1031 without being in the safe harbor, but it could be subject to IRS challenge. 

Conclusion

Like-kind exchanges are tricky.  While the rules presently in place only allow deferred tax treatment on real estate trades, the appropriate reason for holding the properties exchanged must be satisfied.  In addition, mixed use properties can present special problems.  Again, it’s best to seek out competent counsel.  And, one thing I didn’t address, is that often a “qualified intermediary” (Q.I.) must be involved in the exchange to make sure that deferred tax treatment is preserved.  One such Q.I. is a firm in Iowa operated by a colleague of mine (and his wife) that were in law school with me.  They do a fine job.  Let me know if you need assistance on trades and I can point you in the right direction.