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Brooklyn Journal of Corporate, Financial & Commercial Law

First Page

497

Abstract

Section 1031 allows owners of real property to dispose of their property and acquire replacement real property tax-free, and it is one of the most widely used transactional-planning provisions in federal tax law. With the variation in size of the transaction to which section 1031 applies comes varying levels of advice available to property owners. The significant variation in advice that property owners receive affects the actions that they take with respect to their property. Such variation appears to be most pronounced with respect to section 1031 exchanges that occur in proximity to business transactions (i.e., contributions to and distributions from business entities). Some advisors claim that the exchange and proximate business transactions must be separated by some period or separated by a change in tax years. This Article shows that such advice has no support in the law. Despite the lack of support for such advice, the advice persists to the detriment of property owners, especially those who are under-represented. The problem is exacerbated by infrastructure that exists in the section 1031 space to facilitate section 1031 exchanges. Almost every exchange is facilitated by a section 1031 qualified intermediary. The largest section 1031 qualified intermediaries facilitate tens of thousands of exchanges each year. The exchange agents and others working within qualified intermediaries are in contact with tens of thousands of property owners each year. To economize transaction costs, property owners will often look to qualified intermediaries for advice regarding section 1031 exchanges. Because of the wide variation in property owners that engage in section 1031 exchanges and the pressure to keep costs manageable, advisors may attempt to provide general, simplified descriptions of the cases and IRS rulings that consider the qualified-use requirement. The advice may also be designed to minimize property owners’ tax risk. That approach is undermined by the significant variety of transactions that raise the qualified-use requirement. Case law and IRS rulings span various types of qualified-used transactions, each fitting into a category that is governed by its own set of rules. The relevance of qualified-use authority to any given situation depends upon the facts of the authority and the facts of the given situation.Thus, not all qualified-use authority is created equal or treated equally with respect to the various situations that raise the qualified-use requirement.This Article brings order to the qualified-use issue by describing the legally prescribed analysis that applies to tax-law questions such as the section 1031 qualified-use requirement. By categorizing the qualified-use cases and rulings according to transaction type, the Article shows that the law governing the qualified-use requirement is rational and certain with respect to several types of qualified-use exchanges. The failure of property owners and their advisors to accurately understand the law governing the qualified-use requirement could result in multiple types of risk that extend beyond tax risks. First, advice to hold property for a period under the mistaken belief that holding property longer increases the likelihood of satisfying the qualified-use requirement can create transaction risks. For instance, property could lose value, or disagreements among co-owners could arise while property is held longer under the misperception that doing so reduces tax risk. Second, advising clients to hold property longer than is needed with no authority to support such advice exposes advisors to advisory risk. Such risks are reduced when advice is based upon relevant authorities.

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