Like most tax topics, the 1031 exchange has a history of changes, primarily due to various legislative and judicial actions. The essential foundation of this tax-deferral strategy is that when investors reinvest the proceeds from selling an asset, they extend the original investment rather than taking their profit and transforming it into spendable cash. As a result, the IRS allowed investors to trade one property for another without paying the applicable capital gains tax.
The Revenue Act of 1921 legitimized both like-kind and non-like-kind exchanges to encourage citizens to invest. However, the subsequent Revenue Act of 1924 removed the eligibility of non-like-kind exchanges. In addition, later legislation further narrowed down the scope of qualified assets presently limited to real property held for business or investment purposes. Nevertheless, exchanges during this time were still limited to real-time swaps between parties.
However, in 1935 the Board of Tax Appeals allowed a taxpayer to complete an exchange using a Qualified Intermediary to receive the proceeds from the relinquished property’s buyer and then convey the funds to the replacement property seller. This decision established the precedent for the modern-day exchange, which is virtually never an actual property swap.
TJ Starker was a landowner who, in 1979, made a deal with Crown Zellerbach Corporation to exchange timber property for "like-kind" property that was not identified but that Crown promised to convey within five years. The IRS initially rejected the exchange on the grounds that the transaction was not simultaneous. However, the Appeals Court ruled against the IRS, stating that the Federal Tax code did not specify that the exchange must be simultaneous.
Shortly after that, Congress adopted the current 180-day timeline for exchanges and incorporated a 45-day period for the identification of potential replacements. As a result, a “Starker exchange” is the norm in 1031 exchanges, which are rarely simultaneous. In fact, meeting the existing 180-day and 45-day requirements are among the stricter provisions of exchange rules. The difficulty in quickly identifying and acquiring real property has contributed to the prevalence of exchanges using Delaware Statutory Trusts (DSTs) and Real Estate Investment Trusts (REITs) as replacement properties.
Completing a 1031 exchange allows an investor to defer the recognition of applicable capital gains, not waive the tax. If the taxpayer later sells the replacement property without using the 1031 exchange again, they would owe the current and previously deferred taxes. In addition, they potentially would be subject to depreciation recapture as well. To maintain the deferral, the investor must continue disposing of property using the 1031 exchange, thus perpetuating the reinvestment of proceeds.
However, inheritance laws allow the owner of a capital asset to bequeath it to an heir who will receive a step-up in basis upon inheritance. That means the heir receives the asset at its current market value and can sell it without paying a capital gains levy. If the inherited property results from one or a chain of 1031 exchanges, the original investor will effectively have eliminated the imposition of capital gains taxes.