Real Estate and Land Use Hot Sheet -Timely Tax Tip for the Real Estate, Land Use and
Construction Industry
07.29.05
Attention to Detail Crucial For Section 1031 Exchanges
Section 1031 of the Internal Revenue Code of 1986, as amended ("IRC"), provides that no gain
or loss is recognized on the exchange of property held for productive use in a trade or business,
or for investment. Tax law thus allows taxpayers to exchange certain kinds of property for likekind property without immediately paying tax on the gain. The tax is deferred until the
replacement property is ultimately sold. Then, the original deferred gain, plus any additional gain
realized since the purchase of the replacement property, is subject to tax.
Most investors know that real property, whether vacant, rental, commercial, or residential (other
than your primary residence), can qualify for an IRC Section 1031 exchange. Exchanges,
however, can also be used for personal property that is used in a business. Exchanges are a great
way to change, diversify, or consolidate your investment while deferring tax on the gain.
Taxpayers planning an IRC Section 1031 exchange must pay careful attention to all aspects of
the transaction. Even if the exchange involves like-kind property, it may be taxable if it is not
properly planned. Small details can disqualify an otherwise valid IRC Section 1031 exchange.
Here are some often-overlooked areas that, if handled incorrectly, can cause your IRC Section
1031 exchange to be taxable in whole or in part:
Cost Segregation Studies
Since personal property may be depreciated more rapidly than real property, most new buildings
are subjected to a cost segregation study designed to support allocation of the maximum portion
of the construction cost to personal property. While taxpayers often "forget" about this cost
segregation study when they sell or exchange the property, the IRS does not. The key to a
successful IRC Section 1031 exchange is to remember that the property on both sides of the
exchange must be of a "like kind," which means real property can be exchanged only for real
property, and personal property can be exchanged only for the same kind of personal property.
The important thing to remember is to work with your tax attorney to address issues raised by
your cost-segregation study and then to document the value allocation at the time of the
sale/exchange.
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Allocation of Value to the Business
Sometimes, taxpayers think they are selling or exchanging only real estate, when they are
actually also selling intangible property such as goodwill or a franchise. Often, the Purchase and
Sale Agreement, a property tax statement, or a valuation performed in connection with the
decision to sell, will support allocation of part of the consideration to intangibles. In nearly all
cases, the goodwill of one business is considered unique to that business and cannot be
exchanged for goodwill associated with the replacement property - and certainly cannot be
exchanged for real estate. Again, work with your tax attorney to address these issues when
planning your exchange; waiting until the IRS comes knocking is never a good idea.
Dealer Status
IRC Section 1031 exchanges are available for investment property, but not for property "held
primarily for sale." Accordingly, a taxpayer that lists "real estate development" as its business on
its tax return, has business cards or a website that identifies it as a "developer," and/or employs a
real estate SIC code (generally 6552-02) on its Form 1040 Schedule C, may not be eligible for
IRC Section 1031 exchange for property in which they deal. However, even "dealers" can hold
some property for investment (i.e., can qualify some transactions as valid exchanges). Care is
necessary, because the IRS may use the taxpayer's statements of dealer/developer status to
challenge any exchange. Your tax attorney can help you distinguish properties developed for sale
in your business from properties you hold for investment.
Partnership vs. Co-Tenancy
If the owner of the transferred real estate is a partnership, the partnership itself must acquire the
replacement property. Title on the deed is important, but it is not controlling. Remember, for
income tax purposes, a partnership exists whenever two or more persons carry on a business,
financial operation, or venture and divide the profits therefrom. Thus, for example, a tax
partnership exists if co-owners of an apartment building lease space and, in addition, provide
services to the occupants either directly or through an agent. See Treasury Regulation §
301.7701-1(a)(2). There is no hard and fast rule for determining the amount of services that
converts passive real estate ownership by co-tenants into a tax partnership. Think about
amenities associated with the property, such as parking, concierge services, and broadband
access, when addressing this question. Consult a tax attorney when status as either a co-tenancy
or tax partnership is less than 100% clear; it often makes sense to "bring clarity" to the
relationship with a contractual agreement and/or a contribution to, or liquidation of, a tax
partnership in connection with the exchange.
Attention to detail is crucial in a successful Section 1031 exchange. For more information, please
contact any member of our Tax Group.
Lewis M. Horowitz
Neil D. Kimmelfield
Dawn S. Spratley
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Lane Powell PC
206.223.7000 Seattle
503.778.2100 Portland
taxlaw@lanepowell.com
www.lanepowell.com
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