The Revenue Act of 1918 and 1921
Let’s travel back a century in tax law to see how the Section 1031 exchange began and then look at how it evolved into what we have today.
By Al DiNicola, AIF®, CEPA™
January 21, 2023
Adinicola@namcoa.com
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD
The Revenue Act of 1918 and 1921
Let’s travel back a century in tax law to see how the Section 1031 exchange began and then look at how it evolved into what we have today.
The Revenue Act of 1918
According to the IRS’s “Historical Highlights of the IRS” webpage, the Revenue Act of 1918 raised funds for World War I fighting efforts. This act is especially important in tax law because it introduced the first U.S. income tax code. With this act, all tax laws were codified and a progressive income tax rate structure (meaning the percentage of income paid) was implemented, with an upper limit tax rate of 77%. The initial code contained no provision for tax-deferred like-kind property exchanges.
The Revenue Act of 1921
The first “like-kind” exchange law was enacted with the Revenue Act of 1921, allowing property to be sold and a replacement property purchased without taxing any gains earned on the initial property. This law included both like-kind and non-like-kind property exchanges. The 1921 act had two main purposes, according to a white paper issued by the Federation of Exchange Accommodators, “Legislative History of Tax Policies Supporting IRC Section 1031”:
- Avoid unfair taxation of ongoing investments.
- Encourage active reinvestment.
The Revenue Act of 1924
The Revenue Act of 1924 amended the tax code and was notable for prohibiting non-like-kind property exchanges while maintaining the like-kind exchange.
Starker Exchange
A famous 1970s tax case, Starker vs. United States, marked the beginning of tax-deferred like-kind exchange transactions. In 1967, Starker, his son, and his daughter-in-law entered into a land exchange agreement with Crown Zellerbach Corporation to convey interests in 1,800+ acres of Oregon timberland. Crown didn’t have any property that Starker wanted to acquire for his portion of the exchange, so he offered a deal for Crown to consider: Keep an account for the Starkers’ interests, and when they found suitable property, Crown could make the purchase. Crown agreed to acquire and deed the identified properties to the Starker’s within five years. Additionally, Crown agreed to add a “growth factor” of 6% of the outstanding balance to the Starkers’ credit (Starker’s interest and credit was larger than his son and daughter-in-law’s) as compensation for not using and earning on the timberland.
In the first year, the younger Starker’s found land parcels equally valued to their credit amount, which Crown purchased and deeded to them. Starker’s credit balance increased due to the growth factor, and also because completing the transaction took longer owing to his larger interest.
All of the Starker’s completed their 1967 tax returns and reported no gains. However, the market value of the received properties was larger compared with the sold property. They relied on a clause in the Internal Revenue Code’s Section 1031 for nonrecognition of a property’s gain or loss when held for business or investment use and exchanged for like-kind property held for the same use.
The IRS assessed more than $35,000 in deficiencies against the younger Starker’s, and more than $300,000 plus interest against the elder Starker. The Starker’s all paid but filed refund claims. When their refund claims were denied, they filed actions for refunds. The younger Starker’s won their refund claim. The elder Starker’s denied claim was appealed. Ultimately, this case went before the U.S. Supreme Court, and Starker won. However, the IRS took issue with the delay in the exchange and therefore with Starker’s eligibility for the tax liability deferral. But, because no limitation was spelled out in the tax code, Starker hadn’t done anything illegal. Instead, Starker set in motion the beginning of delayed exchange rules. The IRS adopted replacement property identification and exchange period deadlines as a result of this case. The term “Starker exchange” is often used to mean a 1031 exchange or deferred like-kind exchange.
The Starker vs. United States case resulted in a significant tax code change: Deadlines are set for replacement property identification and the exchange period.
The Revenue Reconciliation Act of 1989
The Revenue Reconciliation Act of 1989 limited tax-deferred exchange transactions to those occurring within the U.S. Prior to enactment of this law, investors were allowed to do tax-deferred like-kind exchanges between domestic property and foreign property.
1031 Exchange Applications Today
Today’s 1031 tax-deferred exchange is used to defer paying capital gains taxes on one investment property when an almost immediate repurchase of a like-kind property occurs. Investors can “exchange” property that’s rented out to residential tenants, commercial, industrial, or even leased if the lease is for 30 years or more and includes ownership interest. Investors can exchange into vacant land, hotels, motels, etc., provided the exchange meets certain IRS rules.
Generally, in an exchange of business or investment property solely for business or investment property of a like-kind, no gain or loss is required to be recognized under Internal Revenue Code Section 1031. Using a 1031 tax exchange provides a safe and legal procedure for rolling sales profits into new property as a non-taxable (in the current tax year) event. Anyone considering a 1031 exchange should meet with a qualified tax professional for advice.
An Exchange is Not a Swap
A 1031 exchange isn’t a swap, as the word “exchange” might imply. The parties don’t simply swap properties. In fact, only one of the parties may be conducting an exchange. For the other party, it’s merely a sales transaction, but the exchange is structured such that no money is “received” by the exchanger. In addition, “like-kind” doesn’t mean a condo for a condo. Like-kind means that the exchange involves—at least for the party doing the exchange—business or investment property.
Requirements for Deferring 100% of Tax
To defer 100% of the taxes due, the replacement property must involve an equal or greater level of debt than the relinquished property. If the replacement property doesn’t involve an equal or greater level of debt than the one relinquished, the investor will have to either pay taxes on the “boot” received (proceeds received from the sale that aren’t reinvested in the relinquished property) or put in additional funds at closing (lowering the level of debt in the replacement property). This debt relief is called mortgage boot, and it’s also taxable.
In general, the gain can be deferred from tax liability provided these criteria are met:
- The replacement property is equal to or greater in value than the relinquished property.
- All cash proceeds from the relinquished property are reinvested in the replacement property.
Source: Internal Revenue Code § 1031
Please contact us for a free consultation on how a 1031 tax deferred exchange may benefit you.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin- Sherwood Rd, Suite 200, Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
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