History Lesson on the 1031 Tax Deferred Exchange

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”:

1. Avoid unfair tax­a­tion of ongo­ing invest­ments.
2. 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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