One gripe I often hear when discussing 1031 exchanges is that they are overly shrouded in rules and regulations. While this impression isn’t completely accurate, it’s a fair assessment for someone inexperienced in these transactions.
The technical language and rules surrounding 1031 exchanges can be overwhelming. But once you get through some of the terminology, you’ll find that falling within the bounds of a 1031 exchange is actually a fairly straightforward matter. In fact, the rules of 1031 exchanges have changed throughout the years to make things easier for the investors who partake in them. There have been some key developments in section 1031 that have simplified things for you and the rest of the investment community.
Of course, it’s important to know that even though section 1031 rules have changed over the years to help clarify the process for these exchanges, the best way to navigate the rules is to work with an exchange accommodator (qualified intermediary). This is the surest way to make sure that all rules and regulations are accounted for during your 1031 exchange.
Let’s take a look at how section 1031 has evolved to streamline these transactions, and why the complexity of 1031 exchanges shouldn’t deter potential investors.
The Purpose of Section 1031
When discussing something complex, it often helps to start with some background. Before we dive into the evolution of 1031 exchanges, let’s first mention the two primary purposes that have been at the root of section 1031 since its inception:
- Avoid unfair taxation of theoretical, or on-paper, gains and losses.
- Stimulate economic growth through increased transactional activity.
Whenever like-kind property is exchanged, there will inevitably be some type of “theoretical” (or purely on-paper) gain or loss. In other words, on paper, it may look like an investor is placed in a financially superior position by way of the exchange, but that gain is only theoretical because the investor merely possesses another property of the same type, rather than cash. Section 1031 was developed partly to prevent such theoretical gains from being taxed.
By allowing you and other investors to defer tax consequences that would otherwise be triggered on these gains, section 1031 promotes transactional activity and fosters general economic development. Without section 1031, the tax implications of real property exchanges would undoubtedly result in fewer exchanges and a less fluid marketplace.
The various changes that have been built into section 1031 over the years have been designed to further these two basic goals. Section 1031 has not evolved randomly. Changes have been made to more faithfully reflect its purpose.
A Holistic Approach to 1031 Exchanges
Like other sections of the Internal Revenue Code, section 1031 is shaped by judicial opinions. To thoroughly understand section 1031, we have to look at the various court decisions that have interpreted its terms. Mercantile Trust Co. (1935) and Alderson (1963) are two decisions that helped clarify the bounds of section 1031.
Both of these cases featured complex exchange transactions involving multiple contracts, intermediaries, and contingency clauses. In both cases, the court took a “holistic approach” to classifying section 1031 exchanges and ruled that these transactions should be viewed according to their true “substance” rather than any isolated part. This approach allowed highly complicated transactions to come within the meaning of section 1031 provided that an exchange of like-kind property occurs.
What this means is that 1031 exchanges will often include sophisticated contracts and other complicating factors, but these extraneous items are viewed as less important than the true intent of the participants and the actual outcome of the transaction. In other words, these cases make things easier for you as an investor because you can enter your 1031 exchange and be confident that you will qualify for 1031 treatment even if your transaction is very complex.
Straightforward Rules for Delayed Like-Kind Exchanges
Along with the Mercantile Trust Co. and Alderson decisions, the Starker (1979) decision also led to positive rule changes for investors. In the Starker case, the parties engaged in multiple non-simultaneous, delayed exchanges that occurred over a number of years.
What’s more, replacement properties were not always identified at the outset. Although the Starker decision set a precedent for delayed like-kind exchanges under section 1031, it did not establish fixed deadlines to determine how long a 1031 transaction could take. Congress recognized this gap in section 1031 and acted accordingly.
Under current law, within 45 days of the sale of the original property, investors must identify their replacement property. Within 180 days of the sale of the original property, they must acquire the identified replacement property.
These bright line rules have undoubtedly made things easier for you as an investor. With these fixed deadlines in place, there can be no ambiguity whatsoever as to when vital pieces of your 1031 exchange transaction must be finished. This helps provide investors with peace of mind and keeps the transaction organized.
But, as mentioned earlier, though the rules of section 1031 have evolved to favor you, this does not necessarily mean that they can be tackled effortlessly on your own. Even the most capable investor can still benefit from the expertise of a competent firm. CWS Capital Partners has the section 1031 knowledge needed to assist you with your exchange. Contact us today for information and to get started.
The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
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