There are certain words and phrases that naturally grab your attention: Naked. 80 percent off. Cold beer. Patriots’ tickets.
For the readers of Banker & Tradesman, however, there is one phrase above all else that immediately catches everyone’s interest: Tax-free.
For many years, the real estate industry has understood, benefited and indeed prospered thanks to the good offices of Internal Revenue Code section 1031, a tax-law provision that permits nonrecognition of gain when real property is exchanged for other real property of like kind.
The rules governing like-kind real-estate exchanges are well developed, although surprisingly complex and nuanced at the margins and at the cutting edge. What is less well-known is that like-kind exchanges (LKEs) can also be arranged for many types of property besides real estate. Common LKE transactions include exchanges of airplanes, automobiles and other vehicles, and an increasingly exotic list of other properties, ranging from intellectual property (patents for patents, copyrights for copyrights) to exchanges of fine art and even wines.
The purpose of this article is to review briefly the basic rules, and then to talk about how creative thinking and economic necessity have led to the use of LKEs in new and interesting ways.
The 1031 Basics
The basic rules for a 1031 exchange are well known, but it is always good to remind ourselves about what we already know.
An LKE must involve an exchange of “like kind” property. In addition, the property exchanged in both directions must be held for productive use in a trade or business or for investment. In the real estate industry, the “like kind” requirement is easy: All fee simple real estate is like-kind with all other fee simple real estate. However, this is complicated by the fact that “real estate” has been interpreted in interesting and inventive ways. Real estate that is like-kind to fee simple real estate includes not only land and the improvements thereon, but leaseholds with 30 years or more remaining, including options, and also in certain instances includes air rights, certain kinds of building rights and permits, perpetual riparian (water) rights, and even operating leases in oil and gas drilling.
In addition, the real property must be used in a trade business or held for investment. This is not always straightforward: For example, can a home be used as a personal residence, then rented out to tenants, and then exchanged for other rental or business property? Yes with proper planning.
Starker Regulations
An important (and necessary) element of flexibility is provided by regulations that permit both “deferred” and “reverse” exchanges. In fact, LKEs are rarely a pure “exchange” transaction between two taxpayers. Instead, exchanges are implemented using the so-called “Starker” regulations, which allow a taxpayer, through a paid qualified intermediary (QI), to sell property, have the QI hold the proceeds, and then spend the proceeds on replacement property designated by the taxpayer.
In a simple transaction (these are never really simple), the taxpayer sells the “relinquished” property, and the proceeds are delivered to the QI to be held in a qualified escrow or trust account. The taxpayer then designates up to three replacement properties (or an unlimited number of properties representing up to 200 percent of the value of the relinquished property) within 45 days of the sale transaction. After that, the taxpayer has up to 180 days (measured from the sale of the relinquished property) to close on the acquisition of one or more of the identified properties. If the taxpayer does not identify any properties within 45 days, or if the taxpayer identifies timely but does not close within 180 days, the exchange is “blown” and the original sale transaction becomes fully taxable.
Art, Airplanes, Automobiles And Wine Collections
And then there is everything else. The author this year has been involved in exchanges of:
- A world-famous work of art, in exchange for several Picassos and Warhols (Picassos and Warhols are the most liquid of all art works).
- Several large, private aircraft for several even larger private aircraft – aircraft depreciate rapidly, and if you don’t do an LKE, you pay a staggering tax bill.
- Approximately $5 billion to $10 billion of automobiles and trucks, under “fleet” LKE programs structured to comply with Rev. Proc. 2003-39.
- The exchange, with friends, of several expensive bottles of champagne – which would have qualified as an LKE, except that all the wine was immediately thereafter consumed.
The point is, if you use LKEs to defer gain in the other areas first, you will want to pop the cork and enjoy your wine.
Joseph B. Darby III is a partner at Sullivan & Worcester LLP in Boston, focused on business and transactional tax law.
