The Section 1031 exchange rules can help real estate investors defer paying tax on the transfer of property. Many real estate investors use these rules to upgrade their real estate portfolio over time. This tax deferral can be helpful as monies that would have been paid to the IRS in taxes can be rolled into the next deal.
The Section 1031 exchange rules are complex and nuanced. We help answer a lot of questions about Section 1031 exchanges and plan for tax free exchanges.
The recent Gluck v. Commissioner, No. 21-867 (2nd Cir. 2022) case provides an opportunity to consider one of these nuances. It involves a fact pattern that touches on whether an investor can 1031 exchange into a real estate investment that is jointly held with an existing partnership.
Facts & Procedural History
The taxpayers sold a condo. Shortly after the sale, they purchased an interest in an apartment building. The apartment building was owned by a legal entity that was taxed as a partnership.
The legal entity filed a partnership tax return with the IRS that reflected the taxpayer’s 50 percent interest in exchange for a $17 million dollar capital contribution. It recorded the transaction as a capital contribution in exchange for a partnership interest, rather than a purchase of an interest in the real estate. The partnership issued a Schedule K-1 to the taxpayers consistent with this treatment.
The taxpayers then filed their Form 1040 personal income tax return. Their personal income tax return treated the sale and purchase as a Section 1031 exchange.
The IRS audited the return and determined that the purported Section 1031 exchange was invalid. As a result, the IRS proposed to increase the taxpayers income by more than $1.5 million for the sale of the condo.
About the Section 1031 Exchange
Section 1031 is a timing provision. It allows taxpayers to defer paying taxes on the sale of real estate.
The concept is that taxpayers should not pay income tax on the gain from the sale of property when they are just trading one property for another. Taxpayers should pay tax on the gain on the last property they hold that does not qualify for Section 1031 exchange treatment.
Because Section 1031 applies only to exchanges of property, you do not meet the requirements of Section 1031 if you sell property, takes control of the proceeds from the sale, and then use the proceeds to invest in new property. To facilitate their exchanges, the Section 1031 regulations provide safe harbors for taxpayers, the use of which results in a determination that a taxpayer is not in receipt of the sales proceeds for purposes of Section1031.
For example, taxpayers may use a qualified intermediary (or “QI”) to facilitate their exchanges. When a taxpayer uses a QI, generally he or she will transfer the relinquished property to the QI, who will sell the property to a buyer. The QI will then take the proceeds of the sale of the relinquished property, purchase the replacement property, and transfer the replacement property to the taxpayer. In addition, the QI may use the proceeds from the sale of the relinquished property to fund the construction of the replacement property. If the taxpayer receives the replacement property within the period prescribed and meets the other requirements of Section 1031, the law considers the taxpayer to have engaged in a like-kind exchange of property with the QI and he or she will not recognize gain or loss on the exchange.
Section 1031 accounts for this by requiring the taxpayer to reduce their tax basis in the new property that was acquired. When the property that was acquired is eventually sold, the taxpayer has little or no tax basis left in the acquired property. The result is a tax that is due on the sale of the acquired property.
This is why many real estate investors plan to hold property until they die. If the taxpayer owns the property until the time they die, under current law, their beneficiaries or heirs get a stepped-up tax basis. The law provides that this stepped-up tax basis is equal to the fair market value on the date of death. This stepped-up tax basis is subtracted from the sales price to compute the gain. Since the tax basis is stepped up, there is basically no gain and, as a result, no income tax for the beneficiary or heir.
The “Like Kind” Rules
There are several hurdles one has to clear to qualify for Section 1031 exchange treatment. This includes a requirement that the property that is exchanged be of like-kind.
The Section 1031 exchange rules were changed in 2017 due to the Tax Cuts and Jobs Act (“TCJA”). Congress had considered cutting Section 1031 entirely as part of the TCJA. The hurried way the law was enacted resulted in Section 1031 exchanges surviving, but being limited to real estate. So only real estate qualifies for Section 1031 exchange treatment post-TCJA.
Other than the TCJA limitation, there is a body of law that defines what property is “like kind.” The short version is that just about any real estate interest that involves land will qualify if both the property disposed of and the property acquired include the transfer of land. So a movie theater is like kind to an apartment complex. An apartment complex is like kind to a single family rental property.
Property that is used personally is not like kind, as it is not held for investment or for a business. The same goes for property held for a short period of time. It does not qualify for Section 1031 exchange treatment as it is not held for investment or for business.
The Section 1031 rules also exclude passive investments, such as stocks, bonds, and, as relevant here, partnership interests. With respect to partnership interests, many taxpayers avoid this limitation by distributing the real estate held by the partnership to the partners and then letting each partner execute the Section 1031 exchange. This is referred to as a “drop and swap.” Many tax advisors suggest that one has to hold execute the “drop” and hold the property for a year or more before executing the “swap” so as to not trigger the limit on holding property for investment purposes. Put another way, if one immediately swaps the property right after the drop, the real estate that is relinquished may not meet the held for investment rule. The IRS is well aware of this issue and, in fact, it recently amended its Form 1065 to ask a question about this very issue. The question asks whether this type of transaction has happened during the current tax year. Thus, the reason why many tax advisors suggest that the parties to a drop and swap wait at least one year.
Joint Interest Held by a Partnership
This brings us to this case. The real estate that was acquired was apparently held in a legal entity taxed as a partnership. It filed a partnership tax return that reflected that the taxpayers acquired a 50 percent interest in the partnership for a capital contribution.
The taxpayers argued that they acquired an interest in the real estate that was held by the partnership, not a partnership interest. Thus, they argued that they acquired a joint interest in the real estate held by the partnership. They were a joint owner with the partnership, not a partner in the partnership.
For this to be true, the partnership tax return had to be incorrect. Since the taxpayers went to the trouble to litigate this issue, one has to presume that the partnership return was in fact prepared incorrectly.
The court noted in a footnote that this type of joint interest with a partnership is a possibility:
There may be circumstances in which parties could operate as a partnership for federal tax law purposes while individually owning a real property interest in property used by that partnership. If a property used by a partnership with that type of organization were exchanged, it is possible that it could qualify for like-kind exchange treatment, and the owner’s claimed like-kind exchange would not necessarily be inconsistent with the filing of a partnership tax return.
The court did not reach this issue as the procedural setup of the case did not allow it. The partnership tax return rules (i.e., TEFRA rules) did not give the U.S. Tax Court jurisdiction over the issue. The IRS had sent the taxpayers a statutory notice of deficiency that said the U.S. Tax Court had jurisdiction, but the notice was in error. Since the partnership tax return reported the transaction as a capital contribution, the court concluded that the taxpayers had to dispute the reporting at the partnership level. Thus, the taxpayers have to pay the tax and sue for a refund in district court or the Federal Claims Court.
The Section 1031 exchange rules are complex. There are nuances that have to be considered and planned for. Even one misstep can trigger a sizable tax liability. The planning does not stop with the transaction. As this case shows, it continues on through the tax reporting. A section 1031 exchange involving a joint interest held with a partnership has to be papered correctly and reported correctly. If the tax return for the partnership reports the transaction incorrectly, the investor who is not a partner has to make a filing with their return to say that they are not reporting the deal the same way as the partnership return reported it. By making this filing, they can preserve the right to dispute the Section 1031 exchange treatment in the U.S. Tax Court.