Where did §1031 come from...?

Where did §1031 and “exchanges” come from...?

In 1918, the U.S. enacted its first income tax. At this time, gain or loss was recognized on the sale and disposition of all property. To many legislators, it did not seem fair to impose taxes on dispositions involving an exchange of property when the taxpayer was essentially continuing his investment in real estate. Therefore, Section 202 of the Internal Revenue Code (I.R.C.) was enacted in 1921 which permitted simultaneous Tax-Deferred Exchanges of property.

In 1923, Congress removed stocks, bonds, choses in action, notes and deeds of trusts from exchanges. Later in 1928, §202 was re-enacted as §1031. However, exchanges were still required to be simultaneous, meaning that the parties basically had to sit at a closing and trade their deeds (and possibly cash and/or other taxable property).

Because simply exchanging deeds was such a cumbersome process – and usually did not meet the needs of the exchanging parties – a lawsuit involving a taxpayer, T.J. Starker, made things easier for all of us. In 1979, the landmark tax court case of Starker v. Commissioner (602 F.2d 1341 (9th Cir., 1979) allowed the use of non-simultaneous or “delayed” exchanges, which is what 99% of people do today. This allows someone to sell their property, place the proceeds in trust with a Qualified Intermediary (hopefully, in a separate, interest-bearing account!), and purchase a new property using the proceeds held by the QI.

However, by allowing delayed exchanges, Starker created an administrative nightmare for the IRS and an enormous potential for abuse of the tax code. There were just no ground rules for performing delayed exchanges. Therefore, the IRS passed a number of amendments to §1031 in 1984 to retain more control over exchanges - primarily the 45-day identification period and 180-day closing period. Later, in 1991, the IRS put further controls on §1031, including rules regarding identification of properties (3 properties and the 200% rule), safe harbors to avoid constructive receipt of proceeds, parties disqualified from acting as a QI, and improvement exchange guidelines. Finally, in 2000, the IRS passed safe-harbors for reverse exchanges.

§1031 is a constantly evolving section of the tax code – with plenty of gray areas. Real estate investors need a reliable source for keeping up to date on the latest trends and developments. Please feel free to call The 1031 Exchange Experts with any questions you may have.

--The Experts

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