Those of you who attend Statewide Titleís CLE seminars every year know that for many years we have dedicated a portion of the seminar to Section 1031 tax-deferred exchanges. The segments on 1031 exchanges have become increasingly complex in the last couple of years, so this year we decided to return to the basics: What you think you know, what you know you should know, and what you wish you knew. Some of the answers might surprise you! Here are a few of the questions weíll be addressing this fall:
Q: My clients are selling vacant land. Do they have to buy vacant land as replacement property?
A: No. The definition of "like-kind property" makes distinctions based on real property vs. personal property but does not make any distinctions based on the type of real property exchanged. Any real property held for productive trade or use can be exchanged for any other.
Q: My clients own property zoned for single-use only. Are they required to find replacement property thatís also zoned for the same use?
A: No. Zoning regulations and restrictions are not taken into consideration when determining whether exchange property is like-kind.
Q: My clients want to exchange a vacation home in the mountains as part of a 1031 exchange. Can they do that?
A: It depends. The IRS requires exchange property to be held for productive use in a trade or business, or be investment property. Most vacation homes do not qualify under those requirements.
However, if the home is made available for rent for at least 50 out of 52 weeks, and the owners have reserved no more than 2 weeks for personal use, then a vacation home can qualify. Note that the IRS does not require the home actually be rented 50 weeks, just that it be available for rent that amount of time.
Q: My clients want to buy a home to use as rental property until they retire. Can they do that as part of a 1031 exchange?
A: While there are no specific guidelines about how long property must be held as investment property before converting it to another use, it seems clear that the IRS looks to the taxpayerís intent at the time of the exchange. If the taxpayer intended at the time of purchase to use it as investment property and did, in fact, use it as investment property, then the IRS will probably let the exchange stand. Two years is the guideline that most tax professionals use when advising their clients about a holding period.
Q: My clients are wrapping up a reverse exchange in which they obtained a loan for the purchase of the replacement property. When you get the proceeds from the relinquished property, can you just disburse the proceeds to my clients and let them keep paying on the loan? In other words, what difference does it make where the money goes?
A: No. Tufts v. Commissioner, 103 SCt 1826, 461 US 300, 5/2/83 held that loan funds received to purchase property are not considered a taxable benefit to a taxpayer because the taxpayer is obligated to repay them. Repayment of the loan through the sales proceeds are also considered a non-taxable event because it is simply the discharge of a debt. However, proceeds distributed to a taxpayer -- regardless of any obligation to repay an existing loan -- IS a taxable event. Taxpayers can be reimbursed for funds they directly spent out-of-pocket to pay for the replacement property, but they canít double-dip. They canít get a loan AND get the proceeds and write both off as non-taxable events.
These and numerous other issues will be addressed during our upcoming seminars.