So...you want to play with the big boys. Do you want to turn away from your woes in the stock market and strike it rich in the world of investment grade real estate, but don't have a spare $5,000,000 lying around (See "woes in the stock market" above)? Or perhaps you are looking for an exit strategy for your most recent development, but can't find that investor with a spare $5,000,000 lying around.

An attorney recently lamented to me that some of his clients seem to think all they have to do is yell "1031!" and that magic number will make their capital gains taxes disappear. The utilization of 1031 exchanges by owners of investment or business property has increased dramatically since the final regulations of April 1991¹ went into effect.

Like-kind Exchange Safe-harbor

On August 25, 1997, the Internal Revenue Service issued a Private Letter Ruling that has been hotly debated among exchange experts. PLR 9748006 involved a taxpayer who, through a qualified intermediary, transferred relinquished property to an unrelated buyer and acquired replacement property from his mother. Relying on § 1031(f)(4) of the tax code, the IRS ruled that the transaction did not qualify as a like-kind exchange.

On October 2, 2000 IRS published a new safe harbor for reverse like-kind exchanges.ⁱ This welcome development is the first major change for like-kind exchange transactions since the 1991 final regulations provided safe harbors for standard deferred exchanges.ⁱⁱ The 1991 issuance of deferred exchange regulations resulted in the common practice of utilizing a Qualified Intermediary (QI) to accomplish non-simultaneous like-kind exchanges.

Investment real estate is frequently owned by a partnership of investors who hold title in the partnership's name. Likewise, property owned by tenants in common acting as business or investment partners may be deemed partnership property for tax purposes, regardless of whether or not a formal partnership agreement exists. (See Treas. Reg. §1.761-1(a).) A partnership, as a taxpaying entity, may clearly benefit from capital gains tax deferment by exchanging its qualifying real property assets for like-kind property in a 1031 exchange.

Suppose that as a closing attorney, you have just closed a purchase transaction and recorded the deed. You inform the seller that he can pick up his sales proceeds, but the seller responds, "Oh, by the way, I want to do a 1031 exchange." Is it too late? What about the client who transfers relinquished property in a properly structured exchange, acquires replacement property with part of the exchange funds, and now wants the remaining exchange funds? Can he get his money?

What factors should a tax or real estate advisor consider when determining whether or not properties are "like-kind" to each other in a §1031 exchange? In the context of real property exchanges, the meaning of "like-kind" is generally straightforward. A variety of rulings, however, demonstrate the potential complexity of the definition. Are water rights like-kind to fee simple real estate? Are timber-cutting rights conveyed by timber deed like-kind to fee simple?