The Good, the Bad, and the 1031 Exchange: Deferring Capital Gains Taxes on Property Sales Can Have Unforeseen Consequences
Goddard, G. Jason, Marcum, Bill, The RMA Journal
RELATIONSHIP BANKING HAS never been more in vogue than in the aftermath of the financial crisis. Despite the view that banking is a commodity service with few differences among competitors, financial institutions that focus on long-term relationships and provide value to their customers will be more likely to succeed in the future.
The 1031 exchange concept--by which a property owner disposes of one property and acquires another without having to pay capital gains on the transaction--is, by its very design, relationship-oriented because actions taken in the present will impact the future investment return for the client.
The concept of tax-free exchanges under U.S. tax law has its origins in the Revenue Act of 1921. (1) This article identifies when a transaction may qualify as a 1031 exchange, introduces the economics of the exchange decision, and discusses the unintended consequences of this tax law.
The musician Frank Zappa reportedly said that the United States is a nation of laws, badly written and randomly enforced. While this statement may or may not be accurate, it contains at least a grain of truth in that seemingly well-intended actions sometimes have perverse consequences.
Take, for example, the like-kind exchange under Internal Revenue Code (IRC) section 1031, which provides an exception to the payment of capital gains taxes on the sale of property. These like-kind exchanges, or 1031 exchanges as they are often called, have the stated aim of deferring the capital gains taxes paid in qualifying situations when business or investment property is sold. (2)
In order to qualify for the 1031 exchange, the property sold and the property acquired must be classified for either a business or investment purpose. This is typically an easy hurdle to clear. Additionally, the property must previously have been held for a productive business or investment use, and it is up to the taxpayer to prove that the property being sold was not owned for only a short period of time. Consequently, "flipped" properties do not qualify for 1031 exchanges, although there are no official definitions for what qualifies as the required term of ownership.
One rule of thumb is that the property should be held for at least two years. Two other requirements are that the property purchased must be owned in the same name as the property sold and that both properties must be located either inside the United States or outside of it. That is, if one property is located within the United States and the other is not, the transaction fails to meet the definition of a 1031 exchange. (3)
Someone unfamiliar with like-kind exchanges might think the term refers to something as rigid and specific as selling (relinquishing) one apartment building and buying (replacing it with) another apartment building, but this is not the intention of the like-kind requirement. As long as each property involved in the exchange is classified generally as either for a business or an investment purpose, it is not a requirement that the specified properties match in type. It is our contention that this simple, potentially value-enhancing transaction was yet another piece of coal in the financial meltdown furnace. Ultimately, what determines the value of a 1031 exchange is not the applicability of a particular property to arbitrary, governmental requirements, but rather the impact the deal has on the investor's (i.e., the customer's) long-run returns.
The Different Types of Exchanges
The simplest form of 1031 exchange applies to a simultaneous exchange of one qualified property for another. In this exchange scenario, there is no time interval between the closings of the relinquished and replacement properties.
A second form of 1031 exchange is the delayed or deferred exchange. As the name implies, the delayed exchange applies to transactions not consummated on the same day. …