History of the 1031 Exchange

Section 1031 of the Tax Code has a very long history dating back to 1921.  The first tax code was adopted by the U.S. Congress in 1918 as part of The Revenue Act of 1918, and did not provide for any type of tax-deferred exchange.

The first tax-deferred exchange provision was authorized in The Revenue Act of 1921, when the U.S. Congress created Section 202(c) of the Tax Code, allowing taxpayers to exchange securities and non-like-kind property (such as livestock) unless the property acquired had a "readily realizable market value."

These non-like-kind property provisions were quickly eliminated with the adoption of The Revenue Act of 1924.  The Section number in the Tax Code applicable to tax-deferred exchanges at the time was changed to Section 112(b)(1) with the passage of The Revenue Act of 1928.  In 1935, the Board of Tax Appeals approved the first modern tax-deferred exchange using a Facilitator and the “cash in lieu of” clause was upheld so that it would not invalidate the tax-deferred exchange.

Creation of Section 1031 of the Tax Code

The 1954 Amendment to the Tax Code changed the Section 112(b)(1) number to the present day Section 1031 of the Tax Code and adopted the present day definition and description of a 1031 Exchange, laying the groundwork for the current day structure of the 1031 Exchange transaction.

Starker Family Tax Cases Set Precedent

The tax court cases and corresponding decisions, including an appellate decision from the 9th Circuit Court of Appeals resulting from the now famous Starker family 1031 Exchange transactions, changed the 1031 Exchange industry forever.  The Starker family litigation stemmed from two delayed 1031 Exchange transactions wherein T.J. Starker and son Bruce Starker sold timberland to Crown Zellerback, Inc. in exchange for a contractual promise to acquire and transfer title to properties identified by T.J. Starker and son Bruce Starker within five (5) years.  The IRS disallowed this transaction, contending, among other things, that a delayed exchange did not qualify for non-recognition treatment (i.e. deferral of taxable gains).

These tax court decisions were significant in numerous ways and set the precedent for our present day non-simultaneous, delayed 1031 Exchange transactions.  The Starker family cases demonstrated to the real estate investment industry that non-simultaneous, delayed 1031 Exchanges will qualify for tax-deferred exchange treatment, which provided taxpayers (sellers) with significantly more flexibility in the structuring of 1031 Exchange transactions.

Growth Factor Introduced

In addition, the concept of a “growth factor” was introduced with the Starker family tax court cases.  The Starker family’s 1031 Exchange transactions were structured so that Crown Zellerback would compensate the Starker family with a “growth factor.”  This growth factor was essentially designed to compensate the Starker family with interest income for the lost use (growth) of their timberland and was based on the assumption that timber grew by a certain annual percentage rate, or annual growth rate, each year, and since the Starker family had conveyed or transferred their property to Crown Zellerback with out any immediate compensation they should be compensated for the lost growth rate in timber until their replacement property had been acquired by Crown Zellerback and conveyed or transferred to the Starker family.  The courts ruled that the “growth factor” or “disguised interest” was interest income and must be treated and reported as ordinary income (interest income) but that it was permissible through a 1031 Exchange.

The Starker family's tax court decisions established the need for regulations regarding delayed exchanges and prompted the U.S. Congress to eventually adopt the 45 calendar day Identification Deadline and the 180 calendar day Exchange Period as part of The Deficit Reduction Act of 1984, which also “codified” or adopted the delayed exchange provisions that we have today.  The Deficit Reduction Act of 1984 also amended Section 1031(a)(2) of the Tax Code to specifically disallow exchanges of partnership interests.

The Tax Reform Act of 1986 is responsible for the tremendous explosion in the number of 1031 Exchange transactions administered today.  The 1986 Act eliminated preferential treatment so that all capital gains were taxed as ordinary income, enacted “passive loss” and “at risk” rules, and eliminated accelerated depreciation methods in favor of straight line depreciation consisting of 39 years for commercial property and 27.5 years for residential property.  These changes significantly restricted the tax benefits of owning real estate and catapulted the 1031 Exchange into the lime light as being one of the few income tax benefits left for real property Investors.

Domestic vs. Non-Domestic and Related Party Issues Addressed

The Revenue Reconciliation Act of 1989 resulted in a few changes to the 1031 Exchange arena, including the disqualification of 1031 Exchange transactions between domestic (United States) and non-domestic (foreign) property and placed restrictions on related party tax-deferred like-kind exchange transactions in the form of a two year holding period requirement. 

Tax-Deferred Exchange Regulations Issued by IRS

The long awaited proposed delayed exchange rules and regulations were issued by the Department of the Treasury effective July 2, 1990.  The proposed rules and regulations specifically clarified the 45 calendar day identification period and the 180 calendar day exchange period rules, provided guidance on how to deal with actual and constructive receipt issues in the form of safe harbor provisions, reaffirmed that partnership interests do not qualify as like-kind property in a 1031 Exchange transaction, further clarified the related party rules and continued the role of the Accommodator under the technical name of Qualified Intermediary..

The proposed delayed exchange rules and regulations were issued as final rules and regulations effective June 10, 1991 with only a few minor adjustments, including the further clarification and definition of what constitutes a “simultaneous exchange” and an “improvement exchange,” and which parties were disqualified from serving as a Qualified Intermediary (Accommodator).

The Tax Relief Act of 1997 attempted to significantly change Section 1031 of the Internal Revenue Code, but failed.  There have been a number of attempts to alter portions of the 1031 Exchange code and regulations ever since, but none have been successful to date.

Parking Arrangement Guidelines Issued for Reverse 1031 Exchange Structures

The issuance of Revenue Procedure 2000-37 gave taxpayers and Qualified Intermediaries guidelines on how to structure Reverse 1031 Exchange transactions where the taxpayer's replacement property could be acquired before he or she disposes of his or her relinquished property.  This effectively reduced the risk associated with the 45 calendar day identification period.

Tenant-In-Common (TIC) Investment Property Guidelines Introduced by IRS

The introduction of Revenue Procedure 2002-22 has arguably had the most significant impact on the 1031 Exchange industry since the Tax Reform Act of 1986.  It provided taxpayers with an additional replacement property option that had not existed before — fractional or co-ownership of real estate (CORE) — and is partially responsible for the explosive growth in the volume of 1031 Exchange transactions between 2002 and 2007.

However, after The Great Recession of 2005 to 2009, lenders are very hesitant to lend under a TIC investment property structure, so investors often must look to the Delaware Statutory Trust. 

Delaware Statutory Trusts (DSTs) Guidelines Introduced by the IRS

Revenue Ruling 2004-86 was issued by the Treasury Department paving the way for a whole new way for investors to invest in fractional or co-ownership interests in real property.  Revenue Ruling 2004-86 now permitted Delaware Statutory Trusts or DSTs to qualify as real estate and therefore as a replacement property solution for 1031 Exchange transactions.  Investors could acquire a fractional or percentage interest in the Delaware Statutory Trust as a beneficiary in the DST. 

The end result is very similar to the TIC investment property but in a different legal wrapper, which will have its own nuances to be considered. 

1031 Exchanges Can Be Combined with 121 Exclusion

Revenue Procedure 2005-14 was issued on January 27, 2005.  Revenue Procedure 2005-14 made it possible for taxpayers to use the tax-deferral mechanism of the 1031 Exchange on the sale of their primary residence, if done in conjunction with the specific strategy delineated under the Revenue Procedure 2005-14. 

Taxpayers who have a highly appreciated primary residence (home) with a capital gain that is far in excess of the $250,000/$500,000 tax exclusion provided by Section 121 of the Tax Code, can move out of the property, convert it into rental property, then after a sufficient holding period sell the property and qualify for both the 121 Exclusion and the 1031 Exchange provided the requirements are met.