History of the 1031 Tax-Deferred Exchange in Real Estate

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What is the history of the 1031 tax-deferred exchange? Some investors know that the exchange is a strategy long used by real estate investors. An investor sells investment property and buys or acquires “like-kind” property following the regulations and stipulations of Section 1031 in the Internal Revenue Code (IRC) to defer federal tax, capital gain, and depreciation recapture taxes. “Like-kind” is defined as any type of real estate. You can sell a retail center and buy an apartment building or land in a 1031 exchange; you can sell an office building and buy an industrial building or hotel.

Note: the 1031 tax-deferred exchange is often known as a deferred exchange, a “like-kind” exchange, a Starker exchange (you will see why later in this article), or it is often simply known “a 1031”. No matter what it is called, investors can defer the tax by reinvesting into another investment property if they follow the strict rules. It is one of the tax benefits of investment real estate ownership.

So how did this all come about – what is the history of the tax-deferred exchange?

The tax-deferred exchange actually has a rather long and complicated history dating back to 1921. The first income tax code was adopted in 1918 as part of The Revenue Act of 1918, but it did not provide for any type of tax-deferred exchange. The first tax-deferred exchange was authorized as part of The Revenue Act of 1921 when the United States Congress created Section 2021 of the Internal Revenue Code. Between 1921 and 1970, exchanges were always simultaneous swaps between two parties, by the way.

In 1928, the section number in the Code was changed from 2021 to Section 112(b)(1) with the passage of The Revenue Act of 1928. The 1954 amendment of the Tax Code changed it again, this time to Section 1031 of the Internal Revenue Code, and much of our present language and procedural details were adopted at that time.

However, we can thank the Starker family for the rise of the “deferred exchange”, the way a majority of exchanges are handled today (as opposed to simultaneous swaps). In 1979, a taxpayer named T.J. Starker, transferred timber property (which was free and clear of debt) to Crown Zellerback Corporation in exchange for a promise by Crown to transfer to him like-kind property chosen during a five-year period. At the end of this five-year period, Mr. Starker would receive any outstanding balance in cash. A trust agreement was formed so that all sale proceeds were held in a separate bank account, and clear terms of the trust stated that the funds could only be used to purchase replacement property for the Starker family, and for no other purpose. In fact neither Crown nor Starker even had access to the money except for buying replacement investments. The IRS, upon seeing the arrangement, denier the tax deferral arguing that a 1031 mean a simultaneous swap, which was how the IRS interpreted the code to this time. In a monumental decision, one important for every investor since, the Ninth Circuit Court ruled in favor of Starker and against the IRS, saying the Code did not require simultaneous transactions as a requirement and that the exchange did not fail.

A deferred exchange was a far more feasible way to conduct an exchange, instead of having to find a person to swap a property with simultaneously. But of course it was an administrative nightmare for the IRS, as it would become complicated to track open-ended sales and purchases over unlimited time periods. Long story short, in 1984 and 1986 (Deficit Reduction Act and Tax Reform Act), the 1031 exchange was codified with time limitations and requirements as we know them today. The IRS actually published clear outlines on the subject eleven years after the Starker decision and six years after Congress’ actions. Many tax experts say the regulations are relatively clear, brief, well stated and, for the most part, consistent with the body of case law interpreting Section 1031.

Basic process:

Find a “qualified intermediary” (QI), also known as an “exchange accommodator”, who will hold and transfer the funds, assist with the contract language and various other processes required. You cannot take possession or touch the sales proceeds, or the 1031 will be disallowed and you will pay the tax.

Identify property you intend to acquire (“replacement property”) with your QI no later than 45 days from the sale of your property (“the relinquished property”). The IRS regulations state that the street address or property description used must not be ambiguous.

Close on the new property or properties within 180 days of selling the relinquished property.

Meet or beat the amount of equity and debt from the relinquished property into the new acquisitions to gain full tax deferral.

There are many details to know and understand, so be sure to talk to your real estate agent or an exchange accommodator. Refer to the IRS Web site at http://www.irs.gov.

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Source by Kathy Heshelow