Titles and Deeds

Author: Matthew Riley

PART 2 – The exchanger must intend to hold the replacement property (acquired property) for productive use in a trade or business or for investment purposes.

In Part 1 of this blog series about 1031 like-kind exchanges, we discussed a real estate investor’s relinquished property (the property an investor is selling), and the requirements such property must meet under Section 1031 to qualify for a like-kind exchange.

If an exchanger’s relinquished property meets Section 1031 requirements, then the next set of questions involve the replacement property, which we discuss, here, in Part 2.

One central inquiry is to investigate the exchanger’s intention in acquiring and using the replacement property.  For an exchange to receive tax-deferred treatment, the exchanger must intend to predominantly use the replacement property in furtherance of a trade or business, or as investment property.

Many of the same issues raised in Part 1 about relinquished properties are the same for replacement properties.  Therefore, our discussion about how requisite intent for relinquished property also applies for replacement property.

Here, in Part 2, I will focus attention on particular holding requirements for replacement properties, highlighting two things:

First, a safe-harbor provision for a specific and common type of replacement property––secondary and vacation homes; and secondly, specific requirements unique to replacement property, which the exchanger must meet when selecting such properties.

(a)      Safe Harbor for replacement properties the exchanger intends to use as a second residence or vacation home?

The safe-harbor requirements for secondary residences or vacation homes are the same as I articulated for relinquished secondary or vacation homes. See Part 1.1. For these types of property, Revenue Procedure 2008-16 provides that if the exchanger meets its requirements it has established the requisite intent for the replacement property.

Under the safe-harbor requirements, the exchanger must own the home for two years immediately after the exchange, and for each of those years, or 12-month periods, the Exchanger must both:

(1) Rent the unit at a fair market rate for 14 or more days; AND

(2) Restrict their personal use to the greater of 14 days – OR – 10% of the number of days it was rented at a fair market rate within that 12 month period.

An investor must follow these requirements to defer their taxes under Section 1031.

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Author: Matthew Riley

 How do you characterize vacant and unproductive land that is not used for personal enjoyment nor in furtherance of any trade or business purpose?

As we described in a prior article, for property to qualify for a Like-Kind Exchange the real estate investor must hold it for productive use in a trade or business, or for investment purposes.  But what about property that is unproductive, meaning that it does not provide any profitable income to the owner, or that perhaps even creates losses for them?  What about acquired property that an owner has left untouched or unimproved?

You can read our summary of 1031 Exchanges here. You can read our articles about the tax advantages of real estate here.

Treasury Regulation 1.1031(a)-1(b) explains that “Like-Kind” refers to the “nature of character of the property and not to its grade or quality.”  The regulation further states that “[o]ne kind or class or property may not, under [Section 1031], be exchanged for property of a different kind or class.”

IRS Publication 544 outlines different kinds or classes of property eligible for like-kind exchanges.  Real estate is one kind or class of property, but other property classes exist. The IRS, for example, has created general asset classes for personal property– some of these include the following:

1. Asset Class 00.12 – Information systems, such as computers and peripheral equipment.
2. Asset Class 00.21 – Airplanes (airframes and engines), except planes used in commercial or contract carrying of passengers or friend, and all helicopters (airframes and engines).
3. Asset Class 00.23 – Buses

What Treasury Regulation 1.1031(a)-1(b) does is restrict property exchanges between any two different and distinct classes– an office building considered to be in the real estate class cannot be exchange for a Learjet 85, considered to be in the airplane class or asset class 00.21; The IBM Sequoia supercomputer in the asset class 00.12 cannot be exchanged for a Justin Bieber Tour Bus in the asset class 00.23.

In other words, the IRS is talking about apples and oranges.  Apples can be exchanged for any other apple because they are the same kind of fruit.  But you cannot exchange an apple for an orange, because these are two different types or classes of fruit.  But again, any apple can be exchanged for any other apple.  A Red Delicious apple can be exchanged for a Granny Smith or Fiji; a rotten apple on the ground can be exchanged for one picked from the apple tree.  The reason this analogy works is because the exchange is occurring within the general class of apples, and the differences that exist are due to the variety of types and qualities existing between any two apples within that class.

Under the general and broad property class, “real estate”, there are countless types and qualities of real estate. The IRS is not concerned with the peculiar qualities of the properties being exchanged, whether the property is a warehouse or pasture, profitable or not to the owner, they are only looking to see whether the properties are both classified as real estate.  Whether the land is vacant or unproductive, therefore, is not material to whether the property is eligible for an exchange.

There are, however, two important caveats to this general rule:

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