Every real estate owner and investor should take the time to become acquainted with the elements of section 1031 of the Internal Revenue Code. This section allows taxpayers to defer recognition of either gain or loss when they exchange property of like-kind with another party. For any number of reasons, it may be wise for an owner or investor to exchange their property for another. Sans 1031, an exchange of real property would necessarily involve the realization of either gains or losses, and the management of such realization would require substantial investments of time and money. Section 1031 promotes a more open and free marketplace by eliminating the burdens which traditionally follow real estate sales.
Because of the heavy benefits it confers, section 1031 has rigid qualifications which are narrowly construed by courts. One case which illustrates the narrow reading of section 1031 qualifications is Starker v. United States (1977). As we will see, the plaintiff in this well-known case attempted to expand the construction of section 1031 so as to include a complex, multiyear financial transaction in which he took part. The court rejected the plaintiff’s attempt and set a precedent for a narrow construction of 1031.
Before hearing Starker, the court had just settled an earlier case, known was Starker I, which was heard in 1975 and involved the son and daughter-in-law of the plaintiff of the 1977 Starker case. The plaintiff’s son and daughter-in-law had also taken part in the same transaction which formed the basis for the suit of 1977; like the plaintiff, they tried to receive non-recognition of their capital gain under section 1031. The judge in Starker I concluded that the son and daughter-in-law correctly invoked section 1031 and were therefore entitled to a refund for taxes paid on the transaction. The next Starker case was heard by the same judge; this judge reconsidered his earlier decision and ruled against the plaintiff. As we’ve noted before, sometimes no amount of preparation can account for the whims of our magistrates.
The plaintiff transferred a very large amount of land – approximately 1,843 acres – to a company known as Crown Zellerbach Corporation. In return, the company created an “exchange value” balance on its books. To reduce the balance, the company was supposed to transfer a number of parcels of land to the plaintiff; as part of the agreement, these parcels did not need to be transferred all at the same time, but could be transferred one by one over the course of several years. Collectively, these parcels were supposed to be equal in value to the land given to the company by the plaintiff. The plaintiff also received a “growth factor,” which was interpreted as a type of interest by both the company and the court.
The plaintiff invoked section 1031 when filing the income tax return which included this transaction. The IRS denied this invocation and assessed a tax deficiency of $300,930.31 plus interest. The plaintiff then brought a suit to receive a refund.
The question before the court was whether the plaintiff was in fact entitled to non-recognition under section 1031 given the peculiar characteristics of his exchange.
Under section 1031 of the Internal Revenue Code, taxpayers are entitled to non-recognition of capital gains or losses which arise from the exchange of property of like-kind. The exchange must be reciprocal and involve a present transfer of ownership; it cannot involve a promise to transfer property in the future.
The court disallowed section 1031 and ruled in favor of the government. The court rested its decision on a number of factors. One factor was the element of time: the parties did not simultaneously exchange property of like-kind, but instead created a balance which was to be paid off incrementally over a period of time. And in the event that the parcels of land given to the plaintiff did not settle the balance after a period of five years, the agreement between the plaintiff and company held that the company would then transfer cash to cover the remainder. What’s more, two properties transferred by the company were not actually given directly to the plaintiff; the properties were given to the plaintiff’s daughter. And on another occasion, the plaintiff did not specifically receive the title to a property, but was given cash equal to the purchase price of the property along with the company’s right to acquire the property. These and other factors combined to provide a foundation on which the court made its decision to deny non-recognition treatment.
More than anything, our readers should use the Starker case to see the limited availability of section 1031. Where Starker applies, it can be an incredibly useful tool, but know that it only applies in scenarios which explicitly fall under its requirements.
In our upcoming installments, we will look at sections 1033 and 121 and highlight how these sections can also be of use to taxpayers.
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To learn more about the tax benefits of real estate ownership, please view our presentation by CPA Jessica Chisholm