The section 1031 industry holds a unique place in our economy.2 Section 1031 has become an important and frequently used provision of the Internal Revenue Code. As a provision of tax law, its application requires the use of tax-law analysis, which requires specialized training. Often, the professionals (real estate attorneys and section 1031 qualified intermediaries) closest to section 1031 exchanges lack that critical training.
Section 1031 grants nonrecognition of gain on the disposition of real property if the disposition is structured as part of a qualifying exchange.3 Because section 1031 applies to real property, real estate attorneys are often connected to such transactions. Almost all real estate transactions structured as section 1031 exchanges move through section 1031 qualified intermediaries, so those service providers, as an industry, see hundreds of thousands of real estate transactions each year. The section 1031 qualified intermediary is unregulated,4 so anyone can become a section 1031 qualified intermediary. Thus, the professionals that are typically most closely connected to section 1031 exchanges are real estate attorneys and section 1031 qualified intermediaries.
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This article provides a general overview of the fundamentals of tax-law analysis and shows how the application of such analysis clarifies the authorities governing the four requirements of section 1031.5 It focuses on the application of law to specific types of transactions: section 1031 exchanges that occur in proximity to business transactions (i.e., contributions to and distributions from entities, and those taxed as partnerships for federal income tax purposes in particular). The article presents the fundamentals of tax-law analysis to lay the foundation for considering the application of the law to specific tax questions that arise with respect to section 1031 exchanges that occur in proximity to business transactions: (i) the exchange requirement; (ii) the qualified-use requirement (i.e., the requirement that property be held for productive use in a trade or business or for investment); (iii) the real-property requirement; and (iv) the like-kind requirement.6 The article then examines the law that governs the exchange requirement generally and how it applies specifically to section 1031 exchanges that occur in proximity to business transactions. It shows that the law recognizes the transfer of tax ownership in transitory transactions (i.e., those in which the exchanger acquires property and immediately transfers it) and that courts elevate form over substance to find that exchanges occur. This demonstrates that the law unequivocally supports the qualified-use requirement in exchanges that occur in proximity to tax-free business transactions and confirms that courts recognize the complementary purposes of section 1031 continuity-of-investment and the entity tax rules recognizing that contributions and distributions are changes of the form of ownership but do not disrupt continued investment in property. The article also examines the real-property and like-kind requirements, which come into question if undivided interests in property are transferred as a tax-free distribution prior to an exchange or acquired as part of an exchange preceding a taxfree contribution of the interests to an entity. With such transactions, the interest that an exchanger transfers or receives must be real property and like-kind to other real property. Thus, exchangers should ensure that any co-ownership arrangement is treated as a tenancy-in-common arrangement for federal income tax purposes.
A careful examination of the law shows that there is strong support for granting section 1031 nonrecognition to exchanges that occur in proximity to tax-free business transactions. Despite that support, some advisors continue to advise property owners that they must hold exchange property for some fixed period to satisfy the exchange or qualified-use requirement. The article discusses the tax risks and non-tax risks that exchangers face when structuring exchanges in proximity to business transactions, as well as summarizes some best practices that can help ensure the arrangement is a tenancy in common for federal income tax purposes. That discussion concludes that holding property for a longer period of time does not necessarily reduce tax risk, but extending ownership of property could introduce non-tax risks. Giving advice that is not supported by law also exposes advisors to risks.
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FUNDAMENTALS OF TAX-LAW ANALYSIS
A fundamental task of tax advisors is to apply law to facts and help clients understand the tax ramifications of reporting positions.7 As part of that task, tax advisors may be asked to recommend transaction structures that help reduce or minimize taxes. As part of that process, tax advisors must determine the state of tax law. The tax law governing a specific issue might be certain and easily determinable, certain but not readily determinable, or uncertain, which uncertainty may or may not be easily determinable. Tax advisors must be able to determine the state of the law governing a specific issue and know how to give advice in any particular situation. Determining the state of the law with respect to specific issues requires understanding the basic framework of tax-reporting decision-making and tax-law analysis.
Tax-Reporting Decision-Making
In the transactional setting, taxpayers may be faced with a multitude of decisions related to the position they will report on their tax returns with respect to certain transactions and issues related to those transactions. This analysis does address the decision-making process of taxpayers who act fraudulently and considers the decisions taxpayers must make if they act in a non-fraudulent manner but are interested in minimizing their tax liability. Such taxpayers generally are concerned with three questions: (i) How much will the tax be if I do not take the favorable reporting position? (ii) What is the likelihood that I will have to pay the tax later if I take the favorable reporting position? and (iii) Could I be liable for penalties if I take the favorable reporting position?
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