Capital Gains Rates

Intangibles

As general rule, the goodwill of one entity cannot be exchanged under Section 1031 for the goodwill of another entity.  The IRS, however, recently declared that intangibles such as trademarks, tradenames, mastheads, etc. that can be valued separately and apart from goodwill, may qualify as like-kind property for a Section 1031 exchange.

Transferable Development Rights and Land-Use Credits

In a Private Letter Ruling, the IRS, relying entirely on the classification under the respective state and local law, ruled that transferable development rights and land-use credits were "like-kind" to a fee interest in real estate and therefore, qualified in an exchange with real property under Section 1031.

Disregarded Entities

In a Private Letter Ruling, the IRS ruled the acquisition of a membership interest of a single member disregarded entity did not violate the 1031 prohibition of exchanging into partnership interests.  The State of New Hampshire has imposed stricter rules for disregarded entities and may disallow tax deferment at the state tax level.

Related Party Exchanges

Several IRS Private Letter Rulings (PLRs) on the subject of Related Party Exchanges have been issued during the past few years.  Within the 1031 regulations, a taxpayer may sell property to a related party as long as both parties comply with a two-year holding period.  A 2002 IRS Revenue Procedure indicated a taxpayer may not buy replacement property from a related party.  The recent IRS PLRs have resulted in favorable outcomes for property disposed of within the two year period and for taxpayers wishing to purchase replacement property from a related party.  Although PLRs have no basis in law, it appears the IRS is allowing exceptions to the related party rules where it is evident the parties are not "cashing out" or "basis shifting".  (Related parties include linear relatives and entities in which the Taxpayer owns more than a 50 percent interest.  Not related are aunts, uncles, in-laws, cousins, nephews, nieces and ex-spouses.)

Mixed Use Property

In 2005, the IRS issued a Revenue Procedure clarifying the exclusion of tax on properties used for both business/investment use (Section 1031) and as a principal residence (Section 121).  The procedure provided guidance and examples for mixed use properties consisting of (a) two separate structures used concurrently, e.g. Duplex, (b) single structure used concurrently, e.g. Boarding house, and (c) single structure used consecutively, e.g. converting a principal residence to a rental property. (see our page on Mixed Use Property for more details)

State Tax Issues

Nonresident Withholding Tax - Several states collect an estimated state income/capital gains tax at the time of settlement from nonresident individuals selling a property in their state unless an exemption is requested.  Most states grant a partial or full withholding exemption for 1031 exchanges.  The states that impose a nonresident withholding tax are:  Alabama, California, Colorado, Georgia, Hawaii, Maine, Maryland, Mississippi, New Jersey, New York, Oregon, Rhode Island, South Carolina, Vermont and West Virginia.  Following is the nonresident withholding requirements of New Jersey:

Nonresident individuals, estates or trusts selling an investment property in New Jersey after August 1, 2004, are subject to an estimated withholding tax remitted to New Jersey at the time the deed transfer is recorded.  The estimated tax is a minimum of two percent of the gross sales price or 8.97% of the gain on the property.  Exemptions to the withholding tax include property held by a corporation, partnership or LLC, or non-resident individuals, estates or trusts selling an investment property under a 1031 exchange.   Effective November 16, 2007, nonresident individuals, estates or trusts must make an estimated tax payment for the fair market value of non like-kind property received (e.g. cash).

New Jersey - In September 2006, the New Jersey Administrative Code was amended to state: "A deed transferring real property from one legal entity to another legal entity that has common ownership is subject to the realty transfer fee."  Taxpayers wishing to convey property to/from an LLC, Subchapter S-Corporation, Partnership, etc. may find themselves subject to a significant transfer tax.

Pennsylvania - All taxpayers domiciled in Pennsylvania, except C-Corporations, who exchange real and personal property within the fifty states, must recognize gain on the sale of the property on their Pennsylvania tax return.  The deferral of gain under Section 1031 still applies for federal taxes and the remaining forty-nine states.

Consumer Protection Qualified Intermediary (QI) Legislation - Several states have enacted legislation to protect consumers from the mishandling of 1031 funds by Qualified Intermediaries.  These states include:  California, Colorado, Idaho, Nevada, Virgina and Washington.