Most real estate owners and investors are familiar with the tax laws pertaining to the taxation of gains when a piece of property is sold for more than its “adjusted tax basis.”
There are exceptions to defer the taxation of these gains which one must be concerned with.
Real estate has enjoyed many benefits of the tax free exchange defined in Internal Revenue Code Section 1031 (“1031 Exchange”). The tax free real estate exchange is one of the more significant tax benefits which permit real estate owners to build wealth and save on their taxes.
The 1031 Exchange permits the real estate investor to dispose of his/her real estate interest and use all of the equity to acquire replacement property of equal or greater value, defer the capital gain tax and leverage all of the equity into the replacement property.
The following is a summary of the important criteria which needs to be met in order to qualify for a 1031 Exchange:
- The real estate owner has 45 days from the date the property is sold to identify a replacement property and the closing must be completed within 180 days of the closing of the relinquished property.
- The relinquished, as well as the new property must be “similar in use” and have been held for business use or investment purposes;
- Identification of the property must be specific and in writing and delivered to a qualified intermediary (“QI”) or another qualified party prior to the end of the 45 day period; and
- The exception would be if money was put into a QI’s account and then a real estate tax free exchange takes place from this account.
1031 Exchange property does not includes stocks or property held primarily for sale.
Dulles World Property— Fact Pattern
There are many cases on record which provides a “roadmap” for how the IRS and the Courts view a 1031 Exchange.
There is a new case, still undecided, which will be of considerable interest in this area. Dulles World Property (“Dulles”) is presently in the Tax Court deciding on the merit of a 1031 Exchange entered into in December 2007. Pursuant to an Exchange Agreement between Land America (1031 Exchanges Services, Inc.), QI and Dulles, the parties agreed that the QI would sell the land owned by Dulles World Center, a related company. The QI would receive the net purchase price proceeds and the QI then used the proceeds to purchase the replacement property on behalf of Dulles in accordance with a 1031 Exchange. The transaction seemed to meet all the requirements of a 1031 Exchange. Dulles was audited by the Internal Revenue Service (“IRS) and adjustments were made for 2007 denying the use of the 1031 Exchange for the following reasons:
- The transaction had no non-tax business purpose;
- Substance over form;
- The transaction did not change the parties’ economic interest;
- The transaction terms were not arm’s length; and
- The parties contractually bound each other to respect the form of the transaction.
The IRS felt the transaction was a sham and had no real business purpose other than to avoid the gain on appreciated real estate which was owned by foreign entities.
Our Analysis and Opinion
Upon our review of the Dulles Tax Court Case, we feel there are a number of issues which the IRS has addressed and have a good chance of prevailing. We feel that Dulles may have violated a number of 1031 Exchange provisions and related rules. Essentially, what occurred in this matter was a sale of appreciated U.S. real estate owned by foreign corporations followed by a distribution of the proceeds of the foreign corporation stock through a QI.
Specifically, the provisions that may have been violated were:
- The transaction lacked business substance over form;
- The transaction was motivated by tax consideration;
- There were no non-business purposes;
- This was a non arm’s length transaction;
- The transaction lacks a real potential for profit;
- Boot (cash) was received; and
- The transaction violates IRS Notices 2001-16 and 2008- 111, in which the assets of a corporation are sold following the purported sale of the corporation’s stock.
The IRS may well prevail in the Dulles case. In our opinion, this does not mean that a properly structured real estate sale cannot avail itself of the benefits of a 1031 Exchange. If you own real estate and want to effectuate a 1031 Exchange and avoid the above pitfalls, you should seek sound tax advice before you engage in any 1031 Exchange transactions.