During the past decade there has been a significant increase in the number of taxpayers engaging in Internal Revenue Code Section 1031 like-kind exchanges. In 2003, the last year for which data was published by Deloitte Tax LLP, there were an estimated 220,000 transactions involving about $105 billion in equity. As the popularity of 1031 exchanges has grown, the issues surrounding these transactions naturally have evolved. Recently, several qualified intermediaries' defalcation of exchange funds significantly impacted the like-kind exchange industry, leading to increased federal activity (the proposed Internal Revenue Code Section 468B regulations, issued Feb. 2, 2006, and spurring legislative action at the state level (including the regulation of qualified intermediaries.)

Under IRC Section 1031, a taxpayer may exchange property held for investment or business use, for like-kind property. If the exchange is handled properly, the taxpayer receives a deferral of the capital gains tax associated with the transfer. Any realized gain is deferred until the sale of the replacement property. However, the Internal Revenue Service has imposed mechanical requirements on Section 1031 exchanges, which must be followed if the taxpayer is to achieve a successful tax-deferred exchange. These requirements are set forth in the 1984 Tax Reform Act and the 1991 Treasury Department Regulations, both of which define the structure of Section 1031 exchanges.1

Qualified Properties

In assessing a Section 1031 exchange, a taxpayer must determine whether the properties to be exchanged are eligible to be tax-deferred and whether the property meets the qualified purpose requirement of Section 1031.

Under that section, certain properties are ineligible for like-kind exchange treatment, including inventory,2 stocks and bonds3 and partnership interests.4 Of particular note, Section 1031 specifically excludes certificates of trust or beneficial interests. For purposes of 1031, these represent a right to an interest in the stock of a corporation and therefore do not constitute property qualifying for non-recognition treatment.5

Also, property is ineligible unless it is held by the taxpayer for use in a trade or business, or for investment. The determination as to whether property is held for a qualified purpose is determined at the time the exchange takes place;6 another party's prior or subsequent use of the relinquished or replacement property is immaterial.

Although not determinative, an important consideration in evaluating whether the exchange property meets the qualified purpose requirement is the amount of time that the taxpayer has held the property. While there is no specific holding period, the longer the property has been held, the more likely the taxpayer will be able show the requisite purpose.7

The IRS has shown some flexibility in this area in regard to exchange transactions involving trusts. Notably, in Private Letter Rulings 200521002 and 200651030, the IRS decided that the exchanges in question met the qualified purpose requirement despite the distribution of exchange properties from the respective trusts immediately following or prior to the Section 1031 exchange.

In PLR 200521002, the trust that completed the exchange was to terminate shortly after the exchange, then distribute the replacement property to designated beneficiaries. The IRS stated that the trust termination and subsequent distribution were conducted for purposes independent of the exchange and, therefore, did not violate the qualified purpose requirement.8

In PLR 200651030, there was a termination of a trust and a transfer of the relinquished property to a limited liability company (LLC) shortly before the exchange. The IRS' position was that the members of the LLC were the same as the trust and the LLC was to continue the real estate business of the trust. Also, the exchange transaction was independent of the termination of the trust and, as such, did not violate the qualified purpose requirement.9

To satisfy the exchange requirement of Section 1031, the same taxpayer who disposed of the relinquished property also must acquire the replacement property.10 Very commonly, this issue arises in transactions that involve property held in a trust.11 In exchange transactions, a taxpayer may want to acquire replacement property in a trust, for example, a revocable living trust or a grantor trust. This may be done for various estate-planning reasons. Also, a taxpayer who has held relinquished property in a trust may not want to acquire and hold the replacement property in the trust. Fortunately for him, 1031 permits the taxpayer to chose to make either of these changes and still be able to receive tax-deferred treatment. Under the IRC, neither revocable living trusts nor other grantor trusts are considered separate entities for federal tax purposes.12 Therefore, the grantor, and not the trust, is considered to be the taxpayer for purposes of Section 1031.13. Additionally, a taxpayer may transfer the relinquished property to a grantor trust immediately before an exchange, or transfer the replacement property to a grantor trust after the exchange.14

Like-Kind Requirement

Under Section 1031, the property that taxpayer intends to exchange also must be “like-kind” to the replacement property taxpayer plans to acquire. “Like-kind” refers to the nature or character of the property, not to its grade or quality.15

The regulations provide that real property and personal property may be exchanged. But the distinction between real and personal property is critical, because real property is not like-kind to personal property.16 Rather, real property is like-kind to all other real estate.

Certain trust structures present unique opportunities in regard to the like-kind requirement. For example, for purposes of Section 1031, the IRS has ruled that an interest in a land trust will be considered as an interest in the underlying real property that is held by the land trust.17 As such, the transfer of the interest in the land trust was eligible for tax-deferred treatment and not excluded as a beneficial interest in a trust. However, under the ruling, the trustee's authority was limited to holding title to the real estate at the taxpayer's direction and therefore did not amount to a trust relationship for federal tax purposes.18

A beneficial interest in a Delaware statutory trust (DST) also may be considered an interest in real property that is held by the DST, and therefore eligible as either relinquished property or replacement property in an exchange.19 If so, the beneficial interests in the DST may represent an interest in a grantor trust and the beneficial owners deemed to own undivided fractional interests in the real property for federal tax purposes — and therefore for Section 1031 purposes as well. The critical factor in determining whether property held in a DST qualifies for Section 1031 treatment is the limitations placed on the trustee. For example, if the trustee has the authority or obligation to do more than simply collect and distribute income to the beneficial owners, the DST could be viewed as a business entity, such as a partnership or corporation, and therefore, the interests of the owners would not be eligible for tax-deferred treatment under IRC Section 1031.20

Safe Harbor

A Section 1031 transaction is defined by the exchange of like-kind properties. But if the taxpayer receives proceeds from the sale of the relinquished property before acquiring the replacement property, the transaction constitutes a sale and will not qualify as a tax-deferred exchange.21 Therefore, the central element in structuring a deferred exchange is avoiding receipt of the sale proceeds by the taxpayer.

One of the central purposes of the 1991 regulations was to provide safe harbors for Section 1031 exchanges. The safe harbors provide mechanisms that, if followed, preclude a determination that the taxpayer is in constructive receipt of proceeds from the exchange.

Although the most popular and widely used safe harbor is that for qualified intermediaries (QIs),22 an additional safe harbor allows for qualified escrow accounts and qualified trusts.23 Typically, under this safe harbor, the third party's obligation to acquire and transfer the replacement property to the taxpayer may be secured by cash (or a cash equivalent) if the cash is held in a qualified trust or a qualified escrow account. As with all 1031 exchanges, to qualify under this safe harbor, the qualified trust or qualified escrow must specifically limit the taxpayer's right to receive, pledge, borrow or otherwise obtain the benefits of the relinquished property sale proceeds before the expiration of the exchange period.24 Also, the trustee may not be a disqualified person as defined by the 1991 regulations.25

Better Watch Out

The 1031 exchange industry has recently experienced several high-profile examples in which a QI has been unable to produce exchange proceeds in a timely manner for its clients to purchase replacement property. Unfortunately, these cases involved QIs who lost or failed to adequately secure the funds entrusted to them by taxpayers seeking to do 1031 exchanges. One notable example occurred in the first months of 2007, in which a Nevada-based QI failed to release millions in exchange proceeds for numerous real estate transactions in which taxpayers were acquiring replacement property. As a result, many taxpayers whose funds were held by this QI are now unable to complete the 1031 exchange and, more importantly, may have lost a significant portion of the proceeds from the sale of their relinquished property.26

Even more recently, an individual investor had acquired several regional QIs and consolidated them into a single exchange company providing services to taxpayers throughout the country. The exchange company was forced to file bankruptcy in May 2007 due to an inability to meet the obligations to those taxpayers for whom it held funds.27

If appropriately applied, the qualified trust safe-harbor can provide a mechanism by which the taxpayer can obtain a higher a degree of security for the funds while a QI holds these funds. Through the use of the qualified trust, the taxpayer can ensure that the QI does not solely have full and total control of the exchange funds. Rather, the taxpayer's funds are held in a qualified trust; the QI and trustee must act jointly before any funds are released from the exchange account.

Estate-Planning Tool

When a taxpayer exchanges property under Section 1031, he receives a carryover tax basis in the replacement property. As such, the basis in the replacement property equals the cost of the replacement property reduced by the amount of the gain not recognized in the exchange. Therefore, the carryover basis rules preserve the gain deferred in the 1031 exchange — by creating built-in gain in the replacement property, which must be recognized by the taxpayer on any subsequent sale of the replacement property.28

However, if the taxpayer has completed a like-kind exchange transaction and is holding the replacement property when he dies, his estate would receive a stepped-up tax basis in the replacement property.29 As a result of the stepped-up basis, the estate is able to avoid all of the built-in gain on the replacement property that was preserved by the carryover basis rules.

For many taxpayers, particularly those whose estates may not be subject to federal tax, a like-kind exchange may be an excellent planning tool for the taxpayer to acquire and subsequently transfer property to heirs with no built-in gain.

Those taxpayers whose estates are subject to the federal estate tax will need to analyze whether an exchange is an appropriate planning tool for their circumstances. For example, an estate subject to federal tax can be taxed at varying rates and, as a result, the taxpayer may be in a better position regarding tax liability if he were to gift the relinquished property or the replacement property to his heirs prior to death. Generally, the recipient of the gift will take a carryover basis from the donor and the built-in gain will remain, but the appreciation realized after the gift will not be a part of the estate.30

Even for those taxpayers with larger estates, an exchange may not be a suitable option as the sale of the existing property may be a source of liquidity necessary to pay estate taxes when they die. If the need for liquidity is not satisfied from the estates' other assets, the result may be a forced sale of the replacement property that would offset the tax benefits of the exchange.31

If a taxpayer dies during the exchange period, his estate can complete the exchange.32 Therefore, upon completion of the exchange, the taxpayer's estate is able to defer the tax through the use of the 1031 exchange and also receive a stepped-up basis in the replacement property upon transfer to the heirs pursuant to IRC Section 1014(a). But a word of caution: if the taxpayer or the estate is unable to complete the exchange and fails to acquire replacement property, the disposition of the relinquished property is treated as a taxable sale.33

Proceed Carefully

Tax-deferred exchanges are intended to allow business owners, individuals, and corporations to transfer the full value of one asset or group of assets to another of like-kind without currently paying capital gain taxes on the transaction. While conceptually the transaction appears clear, the taxpayer should seek the advice of tax counsel to determine whether, given the particular property and the current tax situation, it would be favorable to consider a tax-deferred exchange transaction. Tax-deferred exchanges are highly regulated, so due care is essential.


  1. Louis S. Weller and Dean A. Halfacre, data collectors, “§1031 Exchange Market Continues to Grow,” Report, Deloitte Tax, LLP.
  2. Michelle Napoli, “QI Laws Passed in NV, Proposed in CA,” Net Lease Forum, July 3, 2007, at http://www.globest.com/news/941_941/more/162037-1.html.
  3. Internal Revenue Code Section 1031; Treasury Regulations 1.1031.
  4. Treas. Regs. Section 1.1031(a)-1(i).
  5. Treas. Regs. Section 1.1031(a)-1(ii).
  6. Treas. Regs. Section 1.1031(a)-1(iv).
  7. IRC Section 1031(a)(2); See Tax Free Exchange under Section 1031, Section 2.11.
  8. Klarkowski v. Commissioner, T.C. Memo 1965-328, aff'd 385 F.2d 398 (7th Cir. 1967).
  9. See Private Letter Ruling 8429039; the Internal Revenue Service has stated that a two-year holding period would be sufficient for the qualified use test. Private Letter Ruling 200651030.
  10. PLR 200521002.
  11. PLR 200651030.
  12. Chase v. Comm'r, 92 T.C. 869 (1989).
  13. Revenue Ruling 92-105, 1992-2 CB 204.
  14. See IRC Sections 671 to 678.
  15. Treas. Regs. 1.1031(a)-1(b).
  16. Rev. Rul. 59-229, 1959-2 CB 180; Oregon Lumber Co. v. Comm'r, 20 T.C. 192 (1953).
  17. Rev. Rul. 92-105, 1992-2 CB 204.
  18. Ibid.
  19. Rev. Rul. 2004-86 (July 20, 2004).
  20. See Richard M. Lipton, Arnold Harrison and Todd D. Golub, “The Intersection of Delaware Statutory Trusts and Tenancies-in-Common,” Real Estate Tax'n (First Quarter 2005), at p. 76.
  21. See Treas. Regs. Section 1.1031(k)-1(f)(1).
  22. Treas. Regs. Section 1.1031(k)-1(g)(4).
  23. Treas. Regs. Section 1.1031(k)-1(g)(3)(i).
  24. Treas. Regs. Section 1.1031(k)-1(g)(6).
  25. Treas. Regs. Section 1.1031(k)-1(k).
  26. See John G. Edwards, “Southwest Exchange put into receivership,” Las Vegas Review-Journal, Feb. 7, 2007. See also Michael MacPhail, “Is Your Qualified Intermediary a Thief?” Holland & Hart's NASD, SEC and Regulatory Defense Blog, May 31, 2007, at http://securities.blogs.com/hh/2007/05/is_your_qualifi.html.
  27. See Peter Lattman and Kemba Dunham, “Tax Strategy For Real Estate Hits Rocky Turf,” The Wall Street Journal, May 26, 2007).
  28. Tax Free Exchange Under Section 1031, Section 4.2.
  29. IRC Section 1014(a).
  30. See Tax Free Exchange under Section 1031, Section 9.24.
  31. Wagnesen v. Comm'r, 74 T.C. 653 (1980); Click v. Comm'r, 78 T.C. 225 (1982).
  32. Rev. Rul. 64-61, 1964-1 CB 298.
  33. See PLR 9829025; Treas. Regs. Section 1.1031(k)-1(j)(2); Tax Free Exchange under Section 1031, Section 2.41.

David Shaleuly, president, Wachovia Exchange Services, Winston-Salem, N.C.