Navigating Recent Developments in Section 1031 Like-Kind Exchanges

Like-kind exchanges under Internal Revenue Code Section 1031 continues to be a critical tool for real estate investors. This code section can allow taxpayers to defer capital gains taxes on the sale of real property held for investment or as part of a trade or business, provided that the proceeds are timely reinvested into similar "like-kind" properties.

Recent updates have provided further clarity as well as opportunities for investors utilizing Section 1031 exchanges.

Key Updates on Like-Kind Exchanges

In Private Letter Ruling 2023-35002, the IRS clarifies how exchange proceeds can be used to improve replacement properties and still qualify under Section 1031. The ruling specifies that construction-in-process can be included in the exchange value, even if improvements are not fully completed within the 180-day exchange window. This is permissible as long as certain milestones are met and investors show intent for timely completion.

The guidance gives additional flexibility by allowing like-kind exchanges where partial improvements are made on the replacement property, provided the exchange value includes the cost of these improvements.

The Bartell Case and Parking Arrangements in Section 1031 Exchanges

So called “parking arrangements” can be used together with improvement exchanges to further section 1031 benefits.

A pivotal case addressing improvement exchanges and parking arrangements is Estate of Bartell v. Comm'r. This case involved reverse exchanges, where the taxpayer acquires a replacement property before selling the relinquished property.

In the Bartell case, Bartell Drug Co. arranged for a third-party entity (an Exchange Accommodation Titleholder or EAT) to hold the title to the replacement property and make improvements under a “parking arrangement.” This arrangement continued until Bartell sold the relinquished property, completing the exchange.

The IRS argued Bartell’s transaction should not qualify for Section 1031 treatment because the taxpayer had too much control over the replacement property during the improvement phase. However, the Tax Court ruled in favor of the taxpayer, concluding that as long as the EAT holds the title and the taxpayer follows proper exchange protocols, the parking arrangement can qualify as a valid like-kind exchange under Section 1031.

Key Takeaways from the Bartell Case

• Parking Arrangements: The use of an EAT to "park" the replacement property while improvements are made can be an effective strategy for investors facing timing challenges.
• Flexibility in Reverse Exchanges: The Bartell case also highlights the flexibility available to investors conducting reverse exchanges, where the replacement property is acquired before the relinquished property is sold.

Impacts of High Interest Rates and Bonus Depreciation

High interest rates make real estate financing a more complex aspect of the Section 1031 like-kind exchange process. Many investors struggle to meet the strict timelines for identifying and closing on replacement properties due to financing challenges.

To secure financing in this environment, careful planning and consideration of alternative options is necessary. Strategies like using short-term bridge loans or partnering with equity investors can help complete the exchange.

The phase-out of bonus depreciation, which began in 2023, is expected to help Section 1031 exchanges. Previously, many investors preferred cash purchases to take advantage of bonus depreciation, which allowed for immediate deductions on a significant portion of property costs. With the phase-out, like-kind exchanges under Section 1031 may become more appealing, as they enable tax deferral and offer other long-term financial benefits.

Planning for the Future

The future of Section 1031 like-kind exchanges remains a topic of debate. Tax reform discussions frequently consider potential limitations or even the elimination of Section 1031 like-kind exchanges. Some proposals suggest capping the amount of gain that can be deferred or eliminating the provision for high-income investors.

Our tax team monitors legislative developments and can help you structure transactions to maximize tax savings while complying with current regulations.