January 02, 2014
Author: , CCIM, CES
It has become popular for taxpayers who have highly appreciated options or contracts to buy real estate and consider executing a 1031 exchange. This consideration presents several different challenges. Is this type of property qualified property for 1031 exchanges? If so, is this type of interest considered like-kind with taking title to real estate?
To successfully complete a 1031 tax-deferred exchange, a relinquished property must be sold and a like-kind replacement property must be acquired. The like-kind definition for real property is quite broad; any type of real property that is considered “held for investment” is considered like-kind. Two examples: a rental house is considered like-kind with a track of land, and an office building is considered like-kind with a retail strip mall. In addition, a 30-year or longer leasehold interest is considered like-kind with taking or giving title to property. Therefore, if a taxpayer sells a 35-year leasehold interest and subsequently takes title on the replacement acquisition, the like-kind standard will be considered fulfilled. But if the taxpayer sells a 20-year leasehold interest and acquires title on the replacement acquisition, the like-kind standard will not be met because the leasehold interest is less than 30 years.
Can options and contracts be used in a 1031 exchange? There is very little guidance in this area. It is not clear whether an option is considered a real property interest or personal property interest as it applies to 1031 exchanges. If it is considered real property, then a taxpayer may be able to sell an option and acquire title to real property to complete the exchange. That appeared to be the case in Biggs v. Commissioner where the taxpayer received a sales contract as the replacement property.
Furthermore, in Starker v. US one of the replacement properties was a real property contract. However, when analyzed further, the contract was an executory, real property purchase contract where the legal title would not pass to the buyer until the original seller’s life interest expired. During the contract period, the purchaser had the right to live in the property. So these additional attributes may have tipped the scale towards the taxpayer in meeting the like-kind standard.
In certain circumstances, a real estate option or contract may be considered like-kind with receiving a title to real estate. Before exploring this point further, note that it does appear an option or a contract is qualified property for 1031 exchanges.
Therefore, if the taxpayer is selling an option, they should be able to acquire an option and consider the transaction to be like-kind. Similarly, if the taxpayer is selling a real estate contract and acquiring a real estate contract, that transaction would meet the like-kind standard (assuming that the interest was acquired with the intent to be held for investment). The analysis must be much more specific when mixing and matching options and contracts with title to property.
The longer the taxpayer has a right or interest in property, the more likely they will meet the held for investment exchange standard. There is no stipulated timeframe in the Code or Regulations that must be met before a property interest qualifies. A taxpayer who enters into a purchase contract and sells the contract four months later would not have as strong a position as he would if he waited 18 months before selling the contract.
In some geographical areas it has become quite common for investors to enter into reservation agreements, option agreements, pre-construction contracts, etc., for the primary purpose of gaining quick appreciation and immediately selling that right to another party for a profit. This action step is very consistent with the term “property held primarily for sale”. Property that meets this definition does not qualify for 1031 exchange treatment. When a Tax Court analyzes transactions that contain a short holding period, they tend to look very closely at the taxpayer’s original intent. If the intent was to immediately put the property back on the market for a quick, profitable sale, the decision does not usually produce a favorable result for the taxpayer.
In conclusion, there is no clear path or direction on this subject. The water is murky and a taxpayer who is considering an exchange on the relinquished sale of a contract or option and acquiring title to real property for the replacement acquisition would subject themselves to some risk. If this is combined with a quick sale of the interest along with a clear intent to make a quick profit, the transaction is probably doomed. Taxpayers that are considering this type of transaction should seek the guidance of a qualified professional who can assess the potential risk before going forward.
Ron Raitz, CCIM,CESTM, is president and owner of Real Estate Exchange Services, Marietta, Ga. He can be reached at 770/579-1155, Ext. 10 or [email protected]. Information on 1031 exchange transactions is available at www.rees1031.com. Securities offered through Omni Brokerage, Inc. Member NASD/SIPC.
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