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Section 1031 Tax-Deferred Exchanges: The Good, The Bad, And The Proposed Remedy

By Dr. Mark Lee Levine

Although Code §1031 has existed for many decades, there have also been a number of interesting issues to construe and interpret in the application of tax-deferred exchanges under Code §1031. The focus of this Note is to look to some of these issues and, in particular, to examine the basic structure of Code §1031, the advantages and disadvantages to the Section, and to suggest approaches to modify Code §1031 to eliminate some complexity and other troublesome areas concerned with the current application of Code §1031.  

I.           BENEFITS OF CODE §1031:  DETAILS: Code §1031 allows for the deferral of Federal income tax (and potentially the deferral of state tax), assuming one meets the requirements under Code §10311.  If the requirements of Code §1031 have been met by the taxpayer, the taxpayer generally enjoys the deferral of income, and therefore the deferral of taxable gain, not the exclusion of potential taxable income from the disposition of trade or business or investment property.

In 1921, members of Congress recognized that if there were more transactions and the elimination of the hesitancy of undertaking transactions because of tax liability, this would be better for the society.  The approach from the inception of Code §1031 has been to facilitate such tax deferrals.  Not only does Code §1031 support such position, but cases2, Revenue Rulings3, Revenue Procedures4, Regulations5 and other governmental guidance6 often support the position to allow flexibility within Code §1031 transactions.

Current studies7 show that the amount of tax deferral by the employment of Code §1031 is in the billions of dollars each year.  It is clear that taxpayers have been utilizing Code §1031 on a large scale.  The benefits are clearly evident to taxpayers.  They have the opportunity to move from one or more properties to one or more properties and allow for deferral of the tax.  There is not much confusion as to the issue of benefits to taxpayers using Code §1031. (Of course, even though tax deferral may be present, this does not mean that taxpayers should always utilize what they perceive as benefits under Code §1031.  See below.)

Taxpayers may find that the transaction in question is complex, as noted below.  Taxpayers may determine that the timing and other needs for the taxpayer to act are not compatible with the planning for an exchange.   In such instance, taxpayers may choose to not undertake a transaction to dispose of their existing property; or, taxpayers may chose to undertake the transaction and pay the tax (as a “sale”), realizing that the tax deferral did not meet their needs under the given circumstances.


The concern for a taxpayer utilizing Code §1031 is to comply in a way that produces the deferral of taxable income.  If the taxpayer fails to comply, as noted, taxable gain could be generated.  However, even if the taxpayer complies with Code §1031, there can be some risk to the taxpayer.  Such risks may produce very adverse tax and other economic positions to the taxpayer, who was attempting to enjoy the benefits of tax deferral under Code §1031.

Consider, for example:

1.          IMPROPER ACTIONS OF THIRD PARTIES:  One example of such concern, which is examined later in this Note, is the circumstance where a taxpayer had planned to defer tax by having monies held by a third party that were received from the disposition of the taxpayer’s property.  If those funds are not available to the taxpayer, because the third party acts improperly, enters bankruptcy, or otherwise places the funds in jeopardy, the taxpayer faces adverse economic and adverse tax results.

2.         COMPLEXITY: The more commonplace concern for the taxpayer is not with the unusual situation of a problem with a third party, who is involved with facilitating the taxpayer’s exchange.  Rather, the concern for many taxpayers is often the complexity that is involved in undertaking the tax-deferred exchange in some circumstances.  (If such complexity is particularly bothersome to the taxpayer, the taxpayer may choose to pay current income taxes and not use the tax benefits of the exchange.)

Such complexity can result from many of the requirements that are placed on taxpayers when undertaking an exchange that is not simultaneous in nature.  For example, if Mr. X transfers his X-1 property to Miss Y, and Miss Y transfers her Y-1 property to Mr. X, this is straightforward, with little complexity, assuming there are no mortgages, no “non-like-kind” property is involved, and no other unusual circumstances exist.

However, to the contrary, as to the above points, if there are complexities because Mr. X received not only like-kind Y-1 property from Miss Y, but also Mr. X received non-like-kind property, changes in debt owing by X on X-1 property, etc., this may necessitate additional guidance to Mr. X by Mr. X’s CPA, broker, attorney, title company or others who might be involved in various aspects of the exchange.

To avoid these complexities, taxpayers sometimes elect to simply ignore the existence of Code §1031, opting not to use the exchange vehicle.  If Mr. X, the seller, would simply receive monies from the sale and pay tax at the time of the sale.

Whether members of Congress anticipated such complexity when allowing for the tax-deferred exchange remains to be discussed.  However, there is little doubt that there can be great complexity in many exchanges8.

As mentioned, taxpayers must consider not only the position of postponing taxable income, but also the implications of the same.  Because Code §1031 is a deferral section, allowing taxpayers to avoid the tax on a current basis, taxpayers must anticipate that the gain, which is currently postponed, may be generated on future transactions.  (Taxpayers generally prefer to defer tax and have the use of money that would otherwise have been paid in taxes.  Further, taxpayers may anticipate that no tax will ever be paid on the gain, if the taxpayer continues to hold the property until the death9 of the taxpayer.)

Although there are clear advantages to using the exchange approach and deferral, as indicated above, there are many areas of potential disadvantages or negative positions to taxpayers that employ Code §1031.  The potential of gain being taxed in the future, at a higher rate, is a negative consideration for the taxpayer.

If the taxpayer anticipates “selling’ a property to complete the exchange, the taxpayer must acquire a property that is otherwise qualified and within Code §1031, as stated, above.  Thus, taxpayers are not free to simply dispose of the property; they must anticipate that one of the requirements of the exchange is to acquire a replacement property.  This is a factor that has negative implication to some taxpayers; therefore, it will encourage them to sell for cash and pay tax, if they do not wish to acquire replacement property.  Or, the taxpayer might consider not selling or disposing of property in the first place.

Taxpayers should not engage in the exchange approach where the taxpayer has little taxable income.  One advantage of deferring gain is because of the time value of money.  Thus, if there is no tax to be paid, because there is little taxable income by the taxpayer, there would be little incentive to incur the additional requirements of Code §1031 to defer gain, when the gain is slight.

Even if the gain is substantial, taxpayers must anticipate that they should weigh whether Code §1031 should be utilized, if the amount of taxes is not large.  That is, even if the taxpayer has a substantial amount of gain from the disposition of property, the taxpayer may have offsetting losses or credits which would reduce the amount of net tax charged to the taxpayer.  In such instance, the taxpayer should anticipate whether the exchange, and requirements to complete the exchange, outweigh the alternative to simply dispose of the property and receive cash, given the circumstances described.

There are also recent situations in the market that may encourage taxpayers to avoid the use of Code §1031. Consider the following:

1.          DIFFICULT FINANCING MARKET:  Because taxpayers must anticipate, in an exchange, moving from one property owned currently, the relinquished property, to another property, the replacement property, taxpayers must consider if there is a need for additional financing, when acquiring the replacement property.  If the financing cannot be readily obtained, this may discourage the use of an exchange, where financing is problematic.

2.          KNOWN PROPERTY:  Again, if the taxpayer is disposing of a property, this means the taxpayer must also acquire the replacement property.  Moving from a known property, the relinquished property, to an unknown property or position of the replacement property raises concerns for many taxpayers.

3.          PROBLEMS WITH INTERMEDIARIES:  Recent cases indicate that some taxpayers have been placed in jeopardy where they undertook an exchange using a third party.  The third party is often labeled as a Qualified Intermediary.  (The intent of this article is not to examine in detail when a Qualified Intermediary or third party is utilized.  However, for more on this issue, including the use of such Qualified Intermediaries under Code §1031 and Treasury Reg. §1.1031, see this footnote.)10

In other articles I have raised the concern with the potential of an intermediary acting improperly.11

The creation of the need to use third parties to hold funds involved in an exchange was generated as a result of case law and subsequent legislation, which modified Code §1031.  In modifications, subsequent Regulations and other guidance issued by the Treasury, taxpayers that undertake the exchange, such as Mr. X, noted earlier, transferring his X-1 property, must replace the X-1 property.  In summary, the procedures require Mr. X to identify the property he desires as replacement property.  This identification must generally occur within 45 days from the transfer by Mr. X of the X-1 property, the relinquished property.  If Mr. X fails to identify the property within 45 days, as indicated, the exchange is not deferred under Code §1031.  It constitutes a sale.

If the taxpayer can meet the 45-day identification period, the taxpayer must nevertheless complete other requirements.  Some of these include the requirement for the taxpayer to complete the exchange in acquiring the replacement property, within 180 days of the date that the taxpayer transferred the relinquished property.  (In some instances, the 180 days is shortened, such as in the circumstance where the taxpayer’s tax return, including extensions, if any, results in a required filing date of the tax return being due in less than the 180 days.)

Taxpayers can quickly recognize that there are many requirements to meet the Code §1031 criteria to qualify for the tax-deferred exchange.  It is these complexities, along with some of the risks noted herein, that give rise to the quest for other alternatives that might provide the benefits of tax deferral for a taxpayer, benefits to the general public in encouraging the movement of property, and the elimination of many complexities and some confusion that often exists with Code §1031 transactions.

As mentioned, bankruptcy and other actions that impact a third party, who is involved in a transaction between the taxpayer relinquishing his or her property and the acquiring of property from another party, are often at issue.  Such third parties might include not only the Qualified Intermediary, as mentioned, but it might also involve help and guidance from financial planners, real estate brokers, appraisers, attorneys, CPAs, title companies and many other individuals who might provide some help and guidance in given circumstances relative to the real estate transaction involving the exchange.  (Many of these individuals might also be retained when the transaction involves the transfer of real estate for other property, even without an exchange.  However, the complexities involved in many exchanges often necessitate more time and effort by professionals that help guide the taxpayer.)  Whether the Qualified Intermediary or anyone else is involved in a bankruptcy, which might inhibit the ability to complete the exchange on a timely basis, is only one of many issues that may arise and be of concern regarding the current structure under Code §1031.


Although additional considerations may be negative in many instances involving an exchange, it is sufficient to have identified some of these considerations on the negative side, which should be addressed to determine whether alternatives might be created that could allow the benefits of a tax-deferred exchange for the taxpayer and for society, but at the same time eliminate many adverse issues and considerations in such exchange.

This Note is not designed to suggest that Congress should repeal Code §1031.  As mentioned, there are many benefits for users of Code §1031.  It is clear that members of Congress intended to create benefits to taxpayers, allowing them to postpone taxable income.  Members of Congress have supported the continued use of Code §1031.  The use of Code §1031 is advantageous to society to encourage the movement of property.  Having addressed some concerns with some exchanges, the purpose of this Note is to address alternatives that should be considered by Congress.  


I have written a number of articles12  which addressed the issue of complexity and risk considerations involved in Code §1031, because of improper actions by Qualified Intermediaries as well as bankruptcies involving intermediaries.  Some of these sources are noted in the footnotes.  Because of recent cases involving problems with exchanges, these issues should be revisited by Congress.

With a change by Congress, there would be no reason for much of the complexity involving use of Qualified Intermediaries, special time frames with identification, questions as to beneficiaries’ use of funds that are held in escrow pending exchanges, and much more.  Rather, if Congress would chose to restructure Code §1031 in the manner described in this Note13, Congress would find that many of the disadvantages of Code §1031 would be eliminated.  Further, if those issues were eliminated, taxpayers would be much more inclined to undertake exchange transactions, which would further the benefit to society of these exchanges, as discussed earlier in this Note.

If Congress would like to eliminate the concerns of third parties entering bankruptcy, which events have occurred in recent years, the changes, noted below, would solve this problem.

Changes in the law should take place to address the following:

1.          If Congress would choose to change Code §1031, with support from the Administration, along the lines noted below, taxpayers would eliminate the often harrowing concerns with the 45-day identification requirement.  Many brokers would find better and more suitable property for their clients if they were not under the strain that is produced because of the 45-day identification rule.

2.          If taxpayers could have more freedom and time to invest, this would facilitate better due diligence and better reinvestments.

3.          If taxpayers could easily undertake an exchange without the complexities that are often involved in current tax-deferred exchanges, many more taxpayers would consider undertaking exchanges.

The simple suggestion is to restructure Code §1031 to allow the taxpayer to receive cash or other non-like-kind property at the time of transferring the taxpayer’s relinquished property.  That is, if the taxpayer was allowed to receive cash and had a given time period to reinvest the cash, to allow for the deferral of tax when the taxpayer acquires qualified replacement property, this would eliminate many of the areas of confusion and complexity that currently exist within the tax law under Code §1031.

The taxpayer should be given the ability to eliminate the complexities and retain the benefits of an exchange.

Congress allowed, for many years, the use of Code §103414, when a taxpayer disposed of his or her principal residence.  Code §1034 allowed for deferral of tax, if a taxpayer timely reinvested, such as within two years from the time of disposition of the relinquished residence.  What time frame Congress would choose to have for a reinvestment time frame under Code §1031, be it six months, one year, two years or any other time frame, should be discussed.  However, giving the taxpayer the flexibility of receiving cash or other property would mean that the taxpayer would not require the services of a Qualified Intermediary.  (This is not to say that a taxpayer would not use other advisers and experts for facilitating the exchange.  Such advisers might include a title company, attorneys, CPAs, financial advisors, real estate brokers, and many others.)  There would be no need for the taxpayer to take the taxpayer’s funds and place them in the hands of a third party, which third party might improperly utilize those funds. This approach would eliminate most concerns with bankruptcy of a third party holding funds of the taxpayer.

If Code §1031 would allow the taxpayer to dispose of his or her trade or business property or investment property, and allow for tax deferral with reinvesting within a given period, such as six months, the taxpayer would not face many of the hurdles that currently exist for the taxpayer when structuring along the lines mentioned earlier under the current position of Code §1031.

Because of business failures and a difficult economy being faced by taxpayers today, the problem with involving third parties is all that more acute.  This issue should be addressed, to eliminate the need for a taxpayer of relinquished property to place funds in the hands of some third party.  (The great majority of third party Qualified Intermediaries do act properly with regard to exchanges.  However, there is no need do place those funds in the hands of any third party, if Congress changed Code §1031 to follow the approach, mentioned earlier, under the conceptual approach of Code §1034 that applied for the principal residence.)

If Congress wants to retain the benefits of Code §1031 for taxpayers, which position I advocate, Congress should eliminate the complexities and problems of the Tax Code when dealing with third party intermediaries.  This is an example of a change that Congress can make which would be helpful to the public, benefit the taxpayer, generate less problems for the Treasury and the Internal Revenue Service, and facilitate transactions in the real estate community.  (Given economic circumstances today, tax deferrals are needed even more so with the slower economy.)

Those experts in undertaking exchange work today would continue to be in demand for their expertise by taxpayers who would like to have help in structuring transactions and in meeting the requirements of Code §1031.  Title companies that provide for services, including title work, will have demand for their title work.  Such companies facilitate information to evidence good title for a taxpayer that is acquiring replacement property.  However, there is no reason to have many current complexities and risks for taxpayers who are uncertain whether or not to undertake an exchange under the current law.  The modifications suggested should eliminate many of these concerns and would be more fruitful and beneficial for all of those undertaking exchange transactions.

[This is a preview of an article that will soon be published.]

@ Copyright by Dr. Mark Lee Levine, Denver, Colorado, 2010.   All rights reserved.

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  1. See Code §1031(a) and the subsequent portions of Code §1031 that define in more detail the requirements to comply with this Section to defer Federal income tax. Many states dovetail to the rules and follow the same approach as contained in the Federal statute, Code §1031. Generally speaking, the requirements of Code §1031 include an exchange of “qualified” property used in a trade or business or for investment that is considered like-kind between the property given up (relinquished property) for the property received (replacing the relinquished property, called the replacement property).  To have a totally tax-deferred exchange, the taxpayer cannot receive “non-like-kind property.”  For more on this topic, see the specific discussion in Code §1031 and Treasury Reg. § 1.1031, et seq., as well as the discussion in Levine, Mark Lee, Exchanging Real Estate, PP&E, Denver, Colorado (2009).  See Treasury Reg. § 1.1031(a)-1a.
  2. See the cases of  Norman J. Magneson and Beverly G. Magneson v. Comm., 81 T.C. 67 (1983); Norman J. Magneson and Beverly G. Magneson, v. Comm., On Appeal, 753 F.2d 1490 (1985), 85-1 USTC 9205; Joseph R. Bolker v. Comm., 81 T.C. 782, 81 T.C. No. 48 (1983); Joseph R. Bolker, v. Comm., on appeal, 760 F.2d 1039 (1985); 85-1 USTC 9400; Donald DeCleen v. Comm., 115 T.C. No. 34, 115 T.C. 457 (2000).  See also, Exchanging Real Estate, supra, Footnote 1, Chapters 5 and 6.
  3. See such Revenue Rulings as Rev. Rul. 55-749, 1955-2 C.B. 295; Rev. Rul. 71-601, 1972-2 C.B. 467; and Rev. Rul. 78-135, 1978-1 C.B. 256.  See also, Exchanging Real Estate, supra, Footnote 1, Chapter 6.
  4. See Revenue Procedure 2002-22; Revenue Procedure 2000-37.  See also, Exchanging Real Estate, supra, Footnote 1, Chapter 7.
  5. See Treas. Reg. §1.1031(k). and Treas. Reg. §1.1031(a).
  6. See Exchanging Real Estate, supra, Footnote 1, Chapters 5-7.
  7. See Levine, Mark Lee, “Exchanging Fractional Interests and/or Tenancy In Common Interests,” Real Estate Transactions, Tax Planning, Thomson/West, St. Paul, Minnesota (2003).  See also Levine, Mark Lee, “Exchanging Fractional Interests and/or Tenancy In Common Interests,” on Cyberspace Society web internet (5/05).  See http://www.recyber.com “Library” “Dr. Mark Lee Levine.”  Also, see Levine, Mark Lee, “Tenancy In Common (TIC):  A Security or a Real Estate Transaction?” Development, NAIOP-National Association of Industrial and Office Properties 54-57 (Winter, 2006).  Levine, Mark Lee, “TIC:  An Update On the Securities Issue,” Exchanging Real Estate, PP&E, Englewood, Colorado (2008).  See Levine, Mark Lee, “TICs:  An Update On Their Tax Status,” Vol. 20 Real Estate Education Journal, REEA-Real Estate Education Association, (Fall, 2008).
  8. For a discussion of some of the complex issues in tax-deferred exchanges, see Exchanging Real Estate, supra, Footnote 1.  See also the detailed Regulations under Code §1031 as well as hundreds of Revenue Rulings and Revenue Procedures that have discussed complex issues in tax-deferred exchanges. Many of these are cited and/or contained in the two texts, Exchanging Real Estate, supra, Footnote 1 and Levine, Mark Lee, and Segev, Libbi, Real Estate Transactions, Tax Planning, Thomson-West (2010).
  9. See Code §1014.
  10. A great number of cases have been generated which involve a third party holding funds involving in a tax-deferred exchanges, where the third party improperly handled those funds.  They may have improperly utilized the funds, absconded with the funds, or otherwise acted illegally with regard to care and protection of those funds.  For more on this issue, see the following articles dealing with bankruptcy as well as illegal acts by Qualified Intermediaries.  Levine, Mark Lee, “Tax-Deferred Exchanges and Bankruptcy of the Qualified Intermediary:  Lightning Strikes Again,”  Exchanging Real Estate, PP&E (2004).  Levine, Mark Lee, “Tax-Deferred Exchanges and Bankruptcy of the Qualified Intermediary:  LIGHTNING Strikes Again, and Again,” on Cyberspace Society web internet (May, 2005).  See http://www.recyber.com “Library” “Dr. Mark Lee Levine.” Levine, Mark Lee, “Qualified Intermediaries:  Recent Defaults and Bankruptcies:  Code Section 1031,”  Exchanging Real Estate, PP&E, Englewood, Colorado (2009).
  11. See supra, Footnote 9.
  12. See supra, Footnote 8.
  13. See Levine, Mark Lee, “Complexity In the Federal Income Tax Law,” Real Estate Issues, Counselors of Real Estate, Vol. 27, No. 1 (Spring, 2002). Levine, Mark Lee, “Complexity In the Federal Tax Law,” Real Estate Transactions, Tax Planning, The West Group, St. Paul, Minn. (2003).  Levine, Mark Lee, “It’s Time to Simplify Like-Kind Exchange Rules,” Tax Notes/Tax Analysts (6/15/03).   Levine, Mark Lee, and Segev, Libbi Levine, “Reverse Exchanges: Modification of Position by IRS,” Exchanging Real  Estate, PP&E, Englewood, Colorado (2005). Levine, Mark Lee, “Reverse Exchanges: Modification of Position by IRS,” on Cyberspace Society web internet (May, 2005).  See http://www.recyber.com “Library” “Dr. Mark Lee Levine.”  NAR-Radio Interview with Levine regarding Code Section 1031 Tax-Deferred Exchanges, sponsored by NAR-National Association of REALTORS® (Fourth Quarter, 2006) (on write-up on NAR Web site: http://nar.org). Levine, Mark Lee, “Is the U.S. Treasury and IRS Ready To Restrain Code Section 1031 Transactions?”  Exchanging Real Estate, PP&E, Englewood, Colorado (2008).
  14. See Exchanging Real Estate and Real Estate Transactions, Tax Planning, supra Footnotes 2 and 8. Code §1034, as it existed with regard to the residence, has been repealed in favor of taxpayers being allowed an exclusion of gain from the sale of the principal residence, up to given amounts.  This assumes that the taxpayer complies under Code §121.

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