History of the 1031 Exchange

History of the 1031 Exchange
Posted by on Jun 22, 2016

An image of three old-fashioned houses, that represent the long history of 1031 exchanges.If you're just learning about 1031 exchanges, a good place to start is section 1031 of the Internal Revenue Code (IRC), which states that if an investment property is exchanged for a “like-kind” investment property, taxes on capital gains can be deferred. For this reason, a 1031 exchange is an excellent wealth-building strategy, leaving investors with more equity to reinvest in more valuable properties.

But how and why did the 1031 exchange come to be? The basis of the 1031 exchange lies in the idea that when an investor reinvests proceeds in a replacement property it is a continuation of the original investment. Because all sale proceeds are reinvested, it would be unfair to ask the taxpayer to pay taxes with unreceived cash.

It is important to note that the tax obligation is deferred—not eliminated. This means that if a taxpayer sells a relinquished property without a subsequent exchange he or she will be liable to pay taxes on all of their accumulated capital gains.

Early 1900’s

IRC Section 1031 has a long and complicated history. In the early 1900’s, the US government’s need for revenue dramatically increased when it entered World War I. Congress adopted the first income tax code in 1918, as part of the Revenue Act of 1918, but it did not include a provision for a tax-deferred like-kind exchange structure.

The history of the 1031 exchange structure (as we know it now) began with the Revenue Act of 1921 (originally legislated as "Section 202(c)"), which allowed for both like-kind and non-like-kind exchanges. Section 202(c) was designed to provide relief to taxpayers through a deferral strategy, with the hopes that they would continue to reinvest. The non-like-kind exchange was quickly revised by the Revenue Act of 1924, which deemed only like-kind exchanges eligible for tax deferral.

The Board of Tax Appeals approved the first modern tax-deferred like-kind exchange using a qualified intermediary (QI) in 1935. The “cash in lieu of” clause—which permits cash from the sale of one property (rather than the property itself) to be exchanged for a like-kind property—was upheld so that it would not invalidate tax-deferred like-kind exchange transactions.

The tax code remained virtually unchanged for nearly 20 years until the 1954 Amendment to the Federal Tax Code changed Section 112(b)(1) to Section 1031. It also adopted the current definition and description of a tax-deferred like-kind exchange, laying the groundwork for today’s tax-deferred like-kind exchange transaction structure.

Late 1900’s

In 1979, a taxpayer named T.J. Starker transferred timber property to Crown Zellerbach Corporation. The transfer was contingent on Crown’s promise that it would transfer to Starker like-kind property over a five-year period. The IRS denied the tax deferral, arguing that a 1031 exchange requires a simultaneous swap. In a monumental decision that has become important to every 1031 investor since, the Ninth Circuit Court ruled in favor of Starker and against the IRS, saying the Federal Tax Code did not require a simultaneous transaction; the exchange was allowed to go through.

The Starker court decision established the need for additional regulations regarding tax-deferred like-kind exchanges. This prompted Congress to adopt the 45-calendar-day identification deadline and the 180-calendar-day exchange period, as part of the Deficit Reduction Act of 1984.

The Tax Reform Act of 1986 eliminated the preferential capital gain treatment, causing capital gains to be taxed as ordinary income. It also enacted “passive-loss” and “at-risk” rules, and abolished accelerated depreciation methods in favor of straight line depreciation: 39 years for commercial property and 27.5 years for residential property.

In 1989, The Revenue Reconciliation Act resulted in a few changes to the tax-deferred like-kind exchange arena, including disqualifying tax-deferred like-kind exchange transactions between domestic (US) and non-domestic (foreign) property. It also placed a restriction on related-party, tax-deferred like-kind exchange transactions in the form of a two-year holding period requirement.

Proposed tax-deferred like-kind exchange rules and regulations (which had been long-awaited) were issued by the Department of the Treasury in July of 1990. The proposed rules and regulations specifically clarified the 45-calendar-day identification period and the 180-calendar-day exchange period rules. It also provided guidance on dealing with actual and constructive receipt issues, the use of safe harbor provisions, reaffirmed that partnership interests do not qualify as like-kind property in a tax-deferred like-kind exchange transaction, and further clarified the related party rules.

Modern Day

In 2000, the issuance of Revenue Procedure 2000-37 gave investors and qualified intermediaries guidelines on how to structure reverse tax-deferred like-kind exchange transactions, in which the investor’s like-kind replacement property can be acquired before he disposes of his relinquished property.

In 2002, Revenue Procedure 2002-22 was placed in effect, which arguably had the most significant impact on the 1031 exchange industry since the Tax Reform Act of 1986. It provided investors with an additional replacement property option that did not exist before co-ownership of real estate, and is partially responsible for the explosive growth in 1031 exchange transaction volume between 2002 and 2007.

Two years later, the Treasury Department issued Revenue Ruling 2004-86, paving the way for a whole new wave of investors to invest in fractional or co-ownership interests in real property. This ruling permitted Delaware Statutory Trusts (DSTs) to qualify as direct ownership of real estate, and therefore as a replacement property solution for 1031 exchange transactions.

In 2012, the JOBS Act (Jumpstart Our Business Startups) revolutionized the way that people could invest in real estate by allowing private equity crowdfunding (the intent behind the act was to “jumpstart” the US economy). For the first time, accredited investors could access replacement property opportunities via the Internet—making the process of finding suitable properties and completing deals easier than ever.

1031 exchange investing doesn't have to be difficult. That’s why we’ve created an investor guide that tackles the art and science of completing an exchange, and the pitfalls to avoid. What is a 1031 Exchange? features helpful charts, diagrams, timelines, and more. Get your copy today.

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Topics: 1031 Exchange