By Patricia Hughes Mills J.D. LL.M.
Planning elements tied to like-kind exchange transactions are critical to nonrecognition qualifications that turn on why the parties have held their respective properties and a host of other elements. IRC Section 1031 requirements are more complex when real estate and its use, including possible dual-use, is involved in the transaction. Nonrecognition can also depend, in part, on the nature of entities engaged in structuring a real estate deal.
Stock in Trade or Other Property Held Primarily for SaleIRC Section 1031 does not apply to exchanges of stock in trade or other property that is held primarily for sale. This exception refines the requirement that property be held for productive use in a trade or business or for investment. The stock in trade category is intended to exclude real property that is inventory of a dealer. The primary issue that arises under this category is whether a particular taxpayer is a "dealer" in real estate. A considerable and confusing body of case law has developed to distinguish between dealers and nondealers (investors) in real estate. The major source of difficulty here is that property held for investment qualifies only if it is not held primarily for sale, but the very notion of investment implies holding property for future sale. The distinction between holding property primarily for sale and holding property for investment is further complicated by analogous statutory requirements in the capital gains area. Capital gain treatment is not allowed to property held by a taxpayer primarily for sale to customers in the ordinary course of a trade or business.Interests in a PartnershipIRC Section 1031 does not apply to any exchange of interests in a partnership. Thus, a partnership as a taxpayer may exchange real estate for other like-kind property and take advantage of Section 1031. However, a partner may not exchange an interest in a real estate partnership for another partnership interest without triggering a taxable event.The exception for exchanges of partnership interests applies regardless of whether the interests exchanged are general or limited partnership interests, or are interests in the same partnership or in different partnerships.If a partnership is used to hold real estate, careful attention must be paid to any attempts to avoid this limitation on Section 1031. For example, the distribution of an interest in real estate from a partnership to a partner, followed by that partner's exchange of the real estate in a Section 1031 transaction, may still be prohibited by Section 1031. The IRS may assert that the holding requirement has not been met or, applying the step transaction doctrine, may collapse the various steps and determine that the substance of the transactions is an exchange of partnership interests.
Patricia Hughes Mills received her Juris Doctorate degree, magna cum laude, from Syracuse University, and her LL.M. in Taxation, magna cum laude, from the University of San Diego. A past member of the Executive Committee of the State Bar of California Taxation section, Professor Mills practiced law for 15 years before joining Arthur Andersen for several years in their real estate and partnership tax practice. She is now a Professor of Clinical Accounting at the University of Southern California, where she teaches in the Masters of Business Taxation program. She has written several chapters for Powell on Real Property (Michael Allan Wolf, ed., LexisNexis), and is the update author for Federal Taxes Affecting Real Estate (Matthew Bender).
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