Tax overhaul unlikely to target like-kind exchanges

The incoming administration has created a firestorm of discussion of what changes might be made to the tax laws. The general sense is that any changes would be favorable to taxpayers, that is to say net reductions in taxes paid.

One might also expect that the real estate industry would be a winner in any legislative changes. At worst, we might expect that the tax law treatment of real estate will not become worse.

One issue that has been discussed in recent years is elimination of the benefits of Section 1031 like-kind exchanges.

A like-kind exchange allows a deferral of tax when property held for investment or business use is traded for property of a like kind also to be held for business or investment use. Real estate has dominated the like-kind exchange world because the law allows any real property to qualify as like kind to any other real property.

The theory behind allowing a tax deferral is that the taxpayer has continued the same investment in an alternative form. Many tax provisions allow a deferral of gain under similar circumstances.

So why the attack on like-kind exchanges? Well, because there are almost never any actual exchanges. Instead, a taxpayer sells his property and parks the proceeds of sale with an accommodation party. He then finds replacement property and directs the accommodation party to use the parked funds to acquire the property.

The law allows the accommodation structure to be treated as if the taxpayer exchanged with the accommodation party. Whether this is “right” or not, I can’t see it changing under the Trump administration.

What has caused problems, even in the pro-exchange world of old, is when a taxpayer must build replacement property. To make construction work as replacement property, a special accommodation arrangement has been required where the accommodator actually takes title to land while improvements are constructed.

So let’s say that I own an apartment building that I want to sell at a large gain. My goal is to use the sale proceeds to build a new apartment complex. And I don’t want to pay any tax on my gain.

If I sell my complex for $10 million, then buy land for $2 million with planned improvements of $8 million, my exchange will fail.

The reason? While it is easy to qualify real property as like kind, future improvements to be made to my land are not real property and cannot qualify as part of my replacement.

So I get an accommodator to acquire the land. The accommodator builds the improvements. When all the work is completed, I take title as my replacement property.

The IRS has approved this structure, but its procedural rules limit the time the accommodator can own the property to 180 days. Because I cannot get the construction work approved and built within 180 days, the exchange fails.

But a recent Tax Court decision says maybe this plan can work as an exchange. In that decision (Bartell), the accommodator bought the land and finished the improvements in about 12 months. The accommodator then held the finished project for six more months while the taxpayer sold his “old” property to be used in the exchange.

The IRS said this was not an exchange because the taxpayer could not meet the IRS procedural rule (180-day ownership) and the accommodator was not the “real” owner of the property while it was being constructed.

The tax law generally regards the owner of property to be the one who has “benefits and burdens of ownership”— that is, the party who profits if the property appreciates and who suffers if it depreciates is the owner.

Accommodation parties never have these benefits and burdens. So it is generally agreed that it is important to follow the precise IRS procedural guidance for an exchange with construction to avoid an IRS challenge that could point out that the accommodator was not a “real” owner.

In Bartell, the Tax Court seems to suggest that the benefits-and-burdens problem may not be a concern. If so, not only will President Donald Trump likely protect the gardenvariety exchange from attack, but the Tax Court might protect a transaction we previously thought to be taxable.