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History Of The
1031 Exchange
Since we know that 1031 exchanges offer a way to potentially defer capital gains indefinitely, we know that the root of the exchanges lies in the Internal Revenue Code, or the IRC, specifically, section 1031 of the Code. What may surprise many investors is that the exchanges are almost as old as the Code itself.
The first version of the IRC was adopted by Congress in 1918 as part of the Revenue Act of 1918, but did not allow for any tax deferral mechanism involving like-kind exchanges. Three years later, however, the Revenue Act of 1921 enabled investors to defer taxes on exchanges of securities and non-like-kind properties, enumerating these rights in Section 202(c) of the Code. Congress reversed itself quickly, eliminating the non-like-kind property provisions in the Revenue Act of 1924, and subsequently reaffirming deferral on like-kind exchanges in the Revenue Act of 1928, while also moving the relevant language to Section 112(b)(1) of the IRC.
It wasn’t until 1935 that like-kind exchanges began to more closely resemble the format we recognize today, as the Board of Tax Appeals approved like-kind exchanges that not only deferred capital gains taxes for the exchanges of similar assets, but introduced the Qualified Intermediary as an essential part of the transaction. Importantly, the “cash in lieu of” clause, which allowed for the proceeds of the sale of one property to be exchanged for a like-kind property (instead of requiring the exchange of the properties themselves) was also upheld.
Finally, the Internal Revenue Code of 1954 achieved its goal of consolidating the IRC provisions from 1939-1953, revising and renumbering the existing Code sections for overall ease of operations. In so doing, Section 112(b)(1) was reborn as Section 1031 of the Internal Revenue Code, laying the groundwork for the modern structure and functions of the exchanges that bear its name.
Subsequent evolutions of 1031 exchanges broadened their appeal and deepened their value to tax-averse investors seeking to capitalize on appreciated assets while minimizing the bite of taxes.
We’ve used the terms “1031 exchange” and “like-kind exchange” interchangeably; they are also frequently referred to as “Starker exchanges,” or “Starker trusts.”
We’ve used the terms “1031 exchange” and “like-kind exchange” interchangeably; they are also frequently referred to as “Starker exchanges,” or “Starker trusts.” The name stems from a 1979 court case, Starker v. United States, in which the Starker family contested the IRS decision that their sale of timberland to a corporation, in exchange for a contractual promise to acquire and transfer title to properties identified by the Starkers within five years, did not qualify for a deferral of their income tax liabilities. The eventual decisions from the Ninth Circuit Court of Appeals set the precedent for what we now know as non-simultaneous, delayed like-kind exchanges. The Starker decisions also forced Congress to establish regulations governing non-simultaneous, delayed like-kind exchanges. As a result, the Deficit Reduction Act of 1984 introduced the 45-calendar-day identification deadline, as well as the 180-calendar-day exchange period. We’ll be discussing these important timelines in greater detail in future sections of this guide.
Not long after, the Tax Reform Act of 1986 changed the treatment of capital gains, resulting in all capital gains being taxed as ordinary income.
Not long after, the Tax Reform Act of 1986 changed the treatment of capital gains, resulting in all capital gains being taxed as ordinary income. Combined with a handful of accounting changes that accompanied the capital gains tax treatment, the 1031 exchange emerged as one of the few, and best remaining, income tax benefits available to investors, especially those with real property investments.
In 1990, the Department of the Treasury proposed rules which codified and finalized the 45- and 180-day timelines first established in 1984. They also provided guidance on constructive receipt issues, clarifying the definition of “simultaneous” and “improvement” exchanges under Section 1031, and further defining the eligibility of Qualified Intermediaries under Section 1031. These proposed rules were issued as final regulations in June of 1991, and remain an integral basis of 1031 exchanges today.
While other minor tweaks helped to form the current version of the 1031 exchange, the only other major development was the IRS’ decision to issue Revenue Ruling 2004-86, which paved the way for investors to take fractional ownership of interests in real property through Delaware Statutory Trusts, or DSTs. By ruling that DSTs qualified as a suitable replacement property solution for investors seeking to execute a 1031 exchange, it provided investors with an alternative to seeking out one or more real properties on their own, in theory facilitating increased participation in 1031 exchanges for investors.
As the foregoing history demonstrates, 1031 exchanges have existed for decades, and are likely to continue in some form for generations to come. Their evolution also demonstrates the ongoing need for investors to remain vigilant on any and all legislative attempts to strengthen this important tax benefit – or to weaken it. Multiple attempts have been made over the years to alter or even eliminate Section 1031 benefits, and while none has succeeded thus far, future attempts are virtually certain.
Our goal here, and in our Master The 1031 Exchange Masterclass, is not only to educate you on the current state of 1031 exchanges but also to keep you informed on any future changes that may take place.
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