In our previous installment, we learned that whether a transaction falls under section 1031 of the Internal Revenue Code is an extremely important determination. Section 1031 enables taxpayers to receive non-recognition of capital gains when they exchange their real property for another property of like-kind. Real estate transactions can often result in gains of many thousands – and even millions – of dollars, and so receiving non-recognition of this sort under section 1031 can potentially remove very large tax liabilities. For this reason, the qualifications of section 1031 are narrowly construed by courts and so real property owners must carefully observe these qualifications to receive non-recognition treatment.
As with other areas of law, tax law is shaped by judicial opinions. Though the provisions of section 1031 originally emanate from the language of the tax code, the precise contours of these provisions are nonetheless informed and guided by the opinions issued in cases. This is the main reason Huddleston Tax Weekly has focused so heavily on highlighting tax, contract and property cases: it is important that our readers be aware not only of the various laws which may affect them, but also of how these laws apply in real-world scenarios.
The case of Alderson v. Commissioner (1963) gives us a sense of the level of conscientiousness required from the parties of a real estate exchange. As we will explore in detail below, Alderson shows that whether a cash payment is included as a contingency within an agreement is immaterial; the critical factor in determining 1031 treatment is whether an exchange of property of like-kind actually occurred. Alderson also demonstrates that property may be acquired specifically for the purpose of exchanging it as part of a 1031 transaction.
Alderson (the appellant) agreed to sell his property – referred to as Buena Park in the opinion – to a company known as Alloy Die Casting Company. Before the sale was concluded, Alderson decided he would prefer to exchange his property for another property which he discovered after the original agreement was made. This newly discovered property – Salinas – was then acquired by Alloy and transferred to Alderson in exchange for Buena Park.
The amended agreement between Alderson and Alloy included a contingency clause which stated that Alloy would pay cash for the Buena Park property in event that it could not furnish the Salinas property by a specific date.
To receive section 1031 treatment, a transaction must involve the exchange of properties which are of like-kind. The transaction must also be reciprocal and involve a present transfer of ownership, the transfer cannot occur gradually or incrementally over a period of time.
The court (U.S. Court of Appeals for the Ninth Circuit) overturned the opinion of the Tax Court and ruled in favor of Alderson. As noted above, the transaction between Alderson and Alloy was a bit convoluted and involved a formal amendment to the original agreement; two escrow accounts were created as a consequence of the decision made by Alderson to acquire the Salinas property. The Commissioner of Internal Revenue (the respondent) argued that the contingency clause provided evidence for the classification of the transaction as a sale rather than an exchange; the Commissioner also felt that the separate accounts provided evidence for this same conclusion. These arguments ultimately failed to persuade the court.
When determining whether a given transaction falls within the 1031 statute, the court considers the transaction as a whole and bases its decision on the true “substance” of the transaction. Though Alderson did initially agree to a cash sale, and the exchange was complicated by the opening of separate accounts, the substance of the transaction clearly reveals an intention to make an exchange of properties of like-kind. The court does not opine on hypothetical scenarios; the critical fact of Alderson was that the deeds for Buena Park and Salinas were exchanged, not that such an exchange may not have occurred if Salinas were not acquired.
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Property owners should view this video by Jessica Chisholm to learn more about the tax perks of homeownership