LOS ANGELES—Like-kind exchanges under Section 1031 of the Internal Revenue Code are an excellent way to defer recognition of taxable gain on the sale of real property.
In these transactions, a seller of real property assigns the purchase agreement to an exchange accommodator before the closing, and the accommodator sells the property and retains the sale proceeds to use to buy a replacement property for the seller.
If the seller identifies the replacement property within 45 days, and closes on the replacement property within 180 days after the sale (and otherwise complies with some additional rules), gain on the sale is not recognized. However, the tax basis in the replacement property is the seller's basis in the sold (or “relinquished”) property at the time of its sale, not the price of the replacement property. When the replacement property is later sold, the seller in effect eventually pays the tax on the gain on the first sale as well as any additional gain.
It is also possible to do a “reverse” version of this transaction, in which a party can buy the replacement property before it has identified a property it wants to sell. In this version, the party retains an exchange accommodation titleholder (or “EAT”) to buy the replacement property and hold it while the party identifies and finds a buyer for the property it wants to relinquish.
The rules governing these exchanges make it clear that the interests to be exchanged must be real property interests, not, for instance, partnership or limited liability company interests. However there are two useful exceptions. A party may treat membership or partnership interests in its wholly-owned LLC or partnership as equivalent to real property, since the wholly-owned LLC or partnership is disregarded for tax purposes.
The second exception, much less well known, is that a partner or member may also acquire all of the other interests in the LLC or partnership (but not less than all) on a like-kind exchange basis. Normally, like-kind exchanges are done with unrelated third parties as buyers of the relinquished properties and as sellers of the replacement properties. However, it is also possible to do a like-kind exchange with an affiliate. This is useful where, for instance, it is difficult to find a suitable property to relinquish.
This related-party exchange also has the effect of increasing the basis of the sort-of-relinquished property, which is sold to the affiliate for its fair market value. When the sort-of-relinquished property is sold, that sale will then produce a lower taxable gain.
Unsurprisingly, these transactions are subject to arcane and rigid technical requirements, and advice of an experienced accountant or lawyer is critical to their success.
Tom Muller is Co-Chair of the Land Use and Real Estate Practice at Manatt, Phelps & Phillips LLP. This article is for educational purposes only. It is not legal or tax advice or advice to take any action. The information in this article cannot be used to avoid penalties that may be imposed under the Internal Revenue Code or state or local tax laws.
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