Among the business transactions on which the Tax Cuts and Jobs Act[i] has had, and will continue to have, a significant impact is the disposition of a taxpayer’s interest in real property, whether held directly or through a business entity.
That is not to say that the Act amended an existing Code[ii] provision, or added a new provision to the Code, that was specifically intended to affect the income tax consequences arising from the sale or exchange of a taxpayer’s interest in real property. It did no such thing.
However, the Act preserved the ability of a taxpayer to defer the recognition of gain from their disposition of real property (the “relinquished” property) by acquiring other real property (the “replacement” property) of like-kind to the relinquished property,[iii] while eliminating the ability of a taxpayer to engage in a like-kind exchange for the purpose of deferring the gain from their disposition of any other type of property.[iv]
At the same time, the Act provided another deferral option for the consideration of taxpayers who realize capital gain on their disposition of property – including real property; specifically, such gain may be deferred if the taxpayer invests in a new kind of investment vehicle: a qualified opportunity fund (“QOF”).[v]
With the release of proposed regulations under the QOF rules in late 2018,[vi] and with the expectation of more guidance thereunder in the near future,[vii] some taxpayers who are invested in real property are beginning to view QOFs with greater interest, including as a possible deferral alternative to a like-kind exchange.
In light of this development, it will behoove taxpayers invested in real property to familiarize themselves with the basic operation of these two deferral options: the like-kind exchange and the QOF.
We begin with the tried-and-true like-kind exchange.
An exchange of property, like a sale, generally is a taxable event. However, Section 1031 provides that no gain (or loss) will be recognized by a taxpayer if real property held[viii] by the taxpayer for productive use in a trade or business or for investment is exchanged for real property of a “like-kind” which is to be held by the taxpayer for productive use in a trade or business or for investment.
Section 1031 does not apply to any exchange of real property that represents the taxpayer’s stock in trade (i.e., inventory) or other real property held primarily for sale.[ix] It also does not apply to exchanges involving foreign real property[x] – that being said, relinquished real property in one state may be exchanged for replacement real property in another state.[xi]
The disposition of an interest in a partnership or of stock in a corporation will not qualify for tax deferral under Section 1031. However, for purposes of the like-kind exchange rules, an interest in a partnership which has in effect a valid election to be excluded from the application of the Code’s partnership tax rules,[xii] is treated as an interest in each of the partnership’s assets, which may include qualifying real property, and not as an interest in a partnership.[xiii]
For purposes of Section 1031, the determination of whether the real properties exchanged are of a “like-kind” to one another relates to the nature or character of each property, and not to its grade or quality. This rule has been applied very liberally with respect to determining whether real properties are of “like-kind” to one another. For example, improved real property and unimproved real property generally are considered to be property of a “like-kind” as this distinction relates to the grade or quality of the real property.[xiv]
Generally speaking, in order for a taxpayer to defer recognition of the entire gain realized from their disposition of a relinquished real property, the taxpayer must reinvest in the replacement real property an amount at least equal to the sales price for the relinquished property. If the taxpayer invests less than this amount, it may be that they received some cash in the disposition that was not reinvested (non-like property, or “boot”).
In addition, if the relinquished property was encumbered by debt, the taxpayer must incur at least the same amount of debt in acquiring the replacement property, or they must invest additional cash in such acquisition in an amount equal to the amount of such debt.[xv] Any net reduction in such debt, in moving from the relinquished property to the replacement property, would be treated as boot.
The non-recognition of gain in a like-kind exchange applies only to the extent that like-kind property is received in the exchange. Thus, if an exchange of real property would meet the requirements of Section 1031, but for the fact that the property received by the taxpayer in the transaction consists not only of real property that would be permitted to be exchanged on a tax-deferred basis, but also other non-qualifying property or money (including “net debt-relief”), then the gain realized by the taxpayer is required to be recognized, but not in an amount exceeding the fair market value of such other property or money.[xvi]
In general, if Section 1031 applies to an exchange of real properties, the basis of the property received in the exchange is equal to the basis of the property transferred. This basis is increased to the extent of any gain recognized as a result of the receipt of other property or money in the like-kind exchange, and decreased to the extent of any money received by the taxpayer.[xvii]
The holding period of qualifying real property received includes the holding period of the qualifying real property transferred.[xviii]
In this way, the deferred gain is preserved and may be recognized by the taxpayer on a subsequent taxable disposition, which may occur many years later.[xix]
Of course, if the taxpayer is an individual who dies before the later taxable sale of the replacement property, their estate will receive a basis step-up for the property;[xx] consequently, the estate may not recognize any gain on the sale.
A like-kind exchange does not require that the real properties be exchanged simultaneously. Indeed, most exchanges do not involve direct swaps of the relinquished and replacement real properties.
Rather, the real property to be received in the exchange must be received not more than 180 days after the date on which the taxpayer relinquishes the original real property.[xxi]
In addition, the taxpayer must identify the real property to be received within 45 days after the date on which the taxpayer transfers the real property relinquished in the exchange.[xxii]
Until the replacement real property is acquired, the taxpayer may not receive the proceeds from the sale of the relinquished property. If the taxpayer actually or constructively receives such proceeds before the taxpayer actually receives the like-kind replacement property, the transaction will constitute a sale, and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.
In order to assist a taxpayer in avoiding the actual or constructive receipt of money or other property in exchange for their relinquished real property, the IRS has provided a number of “safe harbor” arrangements pursuant to which such “sale proceeds” from the relinquished property may be held by someone other than the taxpayer pending the acquisition of the replacement property.[xxiii] If the requirements for these arrangements are satisfied, the taxpayer will not be treated as having received the sale proceeds.[xxiv]
The same taxpayer[xxv] that disposes of the relinquished property must also acquire the replacement property. Thus, if an individual, a partnership, or a corporation sells a real property that they held for investment or for use in a trade or business, then that same individual, partnership or corporation must acquire and hold the replacement property.
Stated differently, if a partnership or a corporation sells a real property, its individual partners and shareholders cannot acquire their own separate replacement properties outside the partnership or corporation.[xxvi]
There is no prescribed minimum holding period – either for the relinquished property or the replacement property – that must be satisfied in order for a taxpayer to establish that they “held” the real property for the requisite purpose (and not for sale).
However, based on the facts and circumstances, a short holding period may result in a taxpayer’s failing to prove that they held the property for the requisite investment or business purpose.
That being said, a special rule applies where the taxpayer exchanges real property with a related person.
Where a taxpayer engages in a direct swap of like-kind real properties with a related person, the taxpayer cannot use the nonrecognition provisions of Section 1031 if, within 2 years of the date of the swap, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The taxpayer will recognize the deferred gain in the taxable year in which the disposition occurs.[xxvii]
It should also be noted that a taxpayer engaging in a deferred exchange, who transfers relinquished real property to a qualified intermediary in exchange for replacement real property formerly owned by a related party, is generally not entitled to nonrecognition treatment under Section 1031 if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property.[xxviii]
Tomorrow we turn to the Qualified Opportunity Fund.
[i] P.L. 115-97; the “Act.”
[ii] In the words of The Highlander, “There can be only one”: the Internal Revenue Code. Inside joke – part of a running dispute with some acquaintances in the bankruptcy world. Their code has a lower case “c”.
[iii] IRC Sec. 1031.
[iv] Sec. 13303 of the Act. Stated differently, the Act amended the tax-deferred like-kind exchange rules such that they will apply only to dispositions of real property.
[v] IRC Sec. 1400Z-2.
[vii] Treasury Assistant Secretary Kautter recently announced that such regulations were just a few weeks away.
[viii] There is no prescribed holding period, either for the relinquished property or the replacement property. However, a short holding period may result in a taxpayer’s failing to prove that they held the property for the requisite purpose.
[ix] IRC Sec. 1031(a)(2). Thus, a dealer in real property may not use the like-kind exchange rules to defer the recognition of income arising from the sale of their inventory.
[x] IRC Sec. 1031(h).
[xi] Some “relinquished property states” have made noise about keeping tabs on the ultimate taxable disposition of the replacement property; for example, California.
[xii] Subchapter K of the Code. The election is made under IRC Sec. 761. See also the regulations promulgated under Sec. 761.
[xiii] IRC Sec. 1031(e); as amended by the Act.
[xiv] Reg. Sec. 1.1031(a)-1(b). A leasehold interest with a remaining term of at least 30 years is treated as real property. An interest in a Delaware Statutory Trust (basically, a grantor trust) may be treated as real property. In addition, certain intangibles may be treated as real property, including certain development rights.
[xv] Reg. Sec. 1.1031(d)-2.
[xvi] IRC Sec. 1031(b).
[xvii] IRC Sec. 1031(d).
[xviii] The non-qualifying property received is required to begin a new holding period.
[xix] Of course, the taxpayer may decide to continue to defer the gain by engaging in yet another like-kind exchange.
[xx] IRC Sec. 1014. The estate of an individual taxpayer who is a partner in a partnership may enjoy a similar step-up in its share of the underlying real property of the partnership, provided the partnership has in effect, or makes, an election under Sec. 754 of the Code.
The foregoing assumes the sale has not progressed to the point where the contract of sale represents an item of income in respect of a decedent, in which case there will be no basis step-up. IRC Sec. 691.
[xxi] But in no event later than the due date (including extensions) of the taxpayer’s income tax return for the taxable year in which the transfer of the relinquished property occurs).
[xxii] IRC Sec. 1031(a)(3); Reg. Sec. 1.1031(k)-1(a) through (o). The taxpayer may identify more than one replacement property. Regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, the maximum number of replacement properties that the taxpayer may identify is three properties without regard to the FMV of the properties, or any number of properties as long as their aggregate FMV as of the end of the identification period does not exceed 200 percent of the aggregate FMV of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer.
[xxiii] This requires that the proceeds be traced. Form matters here.
[xxiv] Reg. Sec. 1.1031(k)-1(g).
[xxv] Not necessarily the same state law entity. For example, a newly formed single member subsidiary LLC may acquire replacement property following a sale of relinquished property by its parent corporation.
[xxvi] Of course, there are situations in which one partner may want to be cashed out rather than continue in the partnership with a new property, or may want to effect a like-kind exchange while the remaining partners want to cash out their investment. Other strategies may be used in these instances; for example, a so-called “drop-and-swap,” which is not without risk.
[xxvii] IRC Sec. 1031(f). The term “related person” means any person bearing a relationship to the taxpayer described in Sections 267(b) or 707(b)(1) of the Code.
[xxviii] Rev. Rul. 2002-83.