The Anatomy of §1031

Each subsection receives full treatment later in the treatise. This chapter is the map, and its cross-references point to that treatment.

9.1 Subsection (a): the general rule and its exclusions

The text. The general rule is one sentence: "No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment."¹

Its conditions. Read closely, the sentence imposes six conditions. There must be an exchange, as distinguished from a sale for money (Chapter 23). The relinquished property must be real property (Chapter 14) held for productive use in a trade or business or for investment (Chapter 12). It must be exchanged solely for real property, a word that subsections (b) and (c) relax (9.2). The properties must be of like kind (Chapter 15). And the replacement property must be held for productive use or investment. The two permitted purposes are interchangeable: property held for productive use in a trade or business may be exchanged for property held for investment, and the reverse.² Although the sentence does not say so, the taxpayer who relinquishes property must be the taxpayer who receives the replacement (Chapter 18).

The exclusion. Paragraph (2) now reads, in full: "This subsection shall not apply to any exchange of real property held primarily for sale."³ Before 2018 the paragraph also excluded stocks, securities, partnership interests, certificates of trust, and choses in action. Those categories were dropped when the statute was limited to real property, and they now operate through the regulatory definition of real property, which excludes them regardless of State law (7.1, 8.3, and Chapter 13).

Timing. Paragraph (3) supplies the deadlines for deferred exchanges. Property received is "treated as property which is not like-kind property" if it is not identified within 45 days after the relinquished property is transferred or is received after the earlier of 180 days or the due date of the return for the year of the transfer (Chapters 25 and 26).⁴ The paragraph works by recharacterizing late property rather than by disqualifying the transaction. Replacement property that misses a deadline is simply non-qualifying consideration: the exchange fails entirely if nothing else qualifies, and gain is recognized to the extent of that property's value under subsection (b) if other replacement property does qualify.

How the section is organized. Subsection (a) states the rule, and the others qualify it. Subsections (b) and (c) govern exchanges that include money or other property. Subsection (d) supplies the basis of what is received. Subsection (e) treats an interest in a partnership that has elected out of subchapter K as an interest in the partnership's assets. Subsections (f) and (g) withdraw nonrecognition for certain exchanges between related persons, and subsection (h) provides that domestic and foreign real property are not of like kind.⁵ Subsections (b), (c), and (d) also reach beyond section 1031. By their terms they govern exchanges under sections 1035(a), 1036(a), and 1037(a), which concern certain insurance contracts, stock of the same corporation, and certain United States obligations, so section 1031 supplies the boot, loss, and basis rules for four nonrecognition provisions.⁶

9.2 Subsections (b) and (c): recognition of boot; disallowance of loss

Gain. Subsection (b) applies when an exchange would be within subsection (a) "if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money." In that case the gain, if any, is recognized, "but in an amount not in excess of the sum of such money and the fair market value of such other property."⁷ Two limits apply at once: recognized gain cannot exceed the gain realized, and it cannot exceed the boot. A taxpayer who realizes $100,000 of gain and receives $30,000 in cash along with like-kind property recognizes $30,000. A taxpayer who realizes $20,000 of gain and receives the same $30,000 recognizes $20,000.

What counts as boot. Money and other property are boot. Under the last sentence of subsection (d), so is the assumption of the taxpayer's liability by another party to the exchange, "as determined under section 357(d)."⁸ Personal property received with a building is boot, including incidental personal property that the intermediary rules disregard for other purposes (8.4). The netting of liabilities, the treatment of cash the taxpayer pays, and the character of recognized gain are examined in Chapters 33 and 34, and recapture in Chapter 37.

Loss. Subsection (c) addresses the same mixed exchange when the taxpayer has a loss: "no loss from the exchange shall be recognized."⁹ For an exchange solely for like-kind property, subsection (a) already bars recognition of loss, because its rule is that "no gain or loss shall be recognized." Subsection (c) extends the bar to exchanges that include boot. A taxpayer who exchanges property with a basis of $500,000 and a value of $400,000 for like-kind property worth $350,000 plus $50,000 in cash recognizes no loss.

The loss is deferred, not forfeited. Because subsection (d) carries basis forward, a disallowed loss survives as basis in the replacement property. In the example, the replacement property takes a basis of $450,000, the old basis less the $50,000 of cash received, against a value of $350,000. The $100,000 loss is recovered through depreciation or on a later taxable sale.¹⁰ That is why a taxpayer whose property has declined in value should ordinarily sell rather than exchange. A sale allows the loss now, while an exchange defers it for as long as the replacement property is held (Chapters 33 and 35). Because section 1031 is not elective (9.6), the choice has to be made when the transaction is structured, not when the return is prepared.

9.3 Subsection (d): substituted basis

The rule. "If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange."¹¹ In the Code's vocabulary the replacement property is exchanged basis property, because its basis is determined by reference to other property held by the same person, and exchanged basis property is one of the two kinds of substituted basis property (Chapter 2).¹²

How the formula preserves gain. The formula keeps the deferred gain in the replacement property. Suppose a taxpayer exchanges property with a basis of $300,000 and a value of $1,000,000 for like-kind property worth $900,000 plus $100,000 in cash. The taxpayer realizes $700,000 of gain and recognizes $100,000. The replacement property takes a basis of $300,000: the old basis, decreased by the $100,000 of cash and increased by the $100,000 of recognized gain. Its $900,000 value exceeds that basis by $600,000, which is exactly the gain that was not recognized.

Allocation when other property is received. If the taxpayer receives both qualifying property and other property, the basis is allocated between them, and "for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange."¹³ Other property thus takes a fair market value basis, and the qualifying property takes what remains (Chapter 35).

Liabilities. The subsection's last sentence treats another party's assumption of the taxpayer's liability, as determined under section 357(d), as money received, for purposes of section 1031, section 1035(a), and section 1036(a) (9.2). Before 1999 the sentence referred to an assumption of a liability or an acquisition of property subject to a liability; that year Congress substituted the reference to section 357(d) (Chapter 34).¹⁴

What travels with the basis. Because the replacement property's basis is determined by reference to the relinquished property, its holding period generally includes the time the relinquished property was held (Chapter 38). Depreciation of the carried-over basis follows its own continuation rules (Chapter 36), and the recapture provisions generally defer recapture along with the gain (Chapter 37).¹⁵

9.4 Subsections (f) and (g): related persons

The rule. Subsection (f) denies nonrecognition to an exchange between related persons if, within two years after the last transfer that was part of the exchange, the related person disposes of the property it received or the taxpayer disposes of the like-kind property it received. The gain or loss is not reported on an amended return for the year of the exchange; it is "taken into account as of the date on which the disposition . . . occurs."¹⁶ A related person is anyone bearing a relationship to the taxpayer described in section 267(b) or section 707(b)(1).¹⁷

Exceptions and the anti-avoidance clause. Three kinds of dispositions are disregarded: those after the death of the taxpayer or the related person, those in involuntary conversions where the exchange preceded the threat of conversion, and those where it is established to the satisfaction of the Secretary that neither the exchange nor the disposition had tax avoidance as one of its principal purposes.¹⁸ Paragraph (4) denies nonrecognition to "any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection," the clause through which the rules reach exchanges routed through qualified intermediaries (6.2 and Chapter 41).¹⁹

Suspension. Subsection (g) addresses a holder who keeps the property for two years in form while shedding its risk. The two-year period is suspended for any period during which the holder's risk of loss is substantially diminished by holding a put, by another person's holding a right to acquire the property, or by "a short sale or any other transaction."²⁰

Place in the structure. Subsections (f) and (g) are unusual in making nonrecognition depend on events after the exchange. The holding requirement of subsection (a), by contrast, looks to the taxpayer's intent when the exchange occurs, although later conduct may be evidence of that intent (Chapter 12). The history of the related-person rules is in 6.1 and 6.2, and the operative rules are in Chapters 40 and 41.

9.5 Subsection (h): foreign real property

The rule. "Real property located in the United States and real property located outside the United States are not property of a like kind."²¹ When used in a geographical sense, "United States" includes only the States and the District of Columbia, so real property in the territories falls on the foreign side of the line (48.1).²²

History. The rule came from the 1989 conference agreement, which adopted it while rejecting the House's broader proposal to replace the like-kind standard, and which limited it to section 1031 rather than extending it to condemnations under section 1033(g). The conferees added that no inference was intended to override or modify section 932, which concerns residents of the United States and the Virgin Islands (6.1).²³ Congress rewrote the subsection in 1997 to reach foreign personal property as well, and the 2017 Act, which removed personal property from section 1031, returned the subsection to a rule for real property alone.²⁴

What it does and does not reach. The rule divides real property into two classes for like-kind purposes and does nothing more. Foreign real property may still be exchanged for other foreign real property if the other requirements are met. The withholding, reporting, and treaty questions that arise when foreign persons or foreign property are involved are separate, and they are examined in Chapter 48.

9.6 The mandatory, non-elective character of §1031

The text. Section 1031(a) does not offer nonrecognition; it states that no gain or loss "shall be recognized." The general rule of section 1001(c) is that the entire gain or loss on a sale or exchange is recognized "except as otherwise provided in this subtitle," and section 1031 is such a provision. When its conditions are met, it applies whether or not the taxpayer wants it.²⁵

The cases. The courts have said so plainly. In United States v. Vardine, a criminal tax evasion case proved by the net worth method, the government argued that the defendant had waived section 1031 by depreciating trucks and machinery acquired in trade-ins at their full purchase prices. The Second Circuit rejected the argument: "§ 1031 and its predecessor are mandatory, not optional; a taxpayer cannot elect not to use them."²⁶ The Tax Court has stated that "[t]he rules of section 1031 apply automatically; they are not elective."²⁷ In Redwing Carriers, Inc. v. Tomlinson, the Fifth Circuit applied the rule against a trucking company that tried to recognize a loss by having a subsidiary sell its old trucks to the manufacturer while the parent bought new ones. Describing the effort as an attempt to insulate the taxpayer from tax "by means of paper armor," the court treated the transactions as exchanges, disallowed the loss, and rejected the company's contention that section 1031 is elective.²⁸

The contrast with elective provisions. Congress knows how to make nonrecognition elective. Section 1033 provides that no gain is recognized when property is involuntarily converted directly into similar property, but when the conversion produces money, gain is deferred on reinvestment only "at the election of the taxpayer."²⁹ Section 1045 defers gain on the sale of qualified small business stock only for stock "with respect to which such taxpayer elects the application of this section."³⁰ Section 1031 contains no comparable language.

Mandatory in law, a choice in practice. A rule that applies automatically can still be avoided by choosing a different transaction. In Bell Lines, Inc. v. United States, a trucking company sold its old trucks to one buyer and bought new trucks from a manufacturer under a contract that bound it whether or not the old trucks were sold. The Commissioner argued that the replacement was an exchange, which would have reduced the basis of the new trucks. The Fourth Circuit held that because the transactions were not mutually dependent and the company had legitimate business reasons for separating them, they were a sale and a purchase, and it distinguished Redwing Carriers on that ground.³¹ A taxpayer who wants to recognize a loss, or who prefers a cost basis, must therefore arrange a genuine sale before the transaction occurs. Nothing can be elected on the return (Chapter 3, 35.3, and 53.4).

Consequences. The mandatory character explains several features of the law. It is why a loss inside a qualifying exchange cannot be claimed (9.2), why a transaction that meets the requirements without any planning still produces nonrecognition, as the trade-ins in Vardine did, and why the government can invoke section 1031 against a taxpayer, as it did in Redwing Carriers and attempted to do in Bell Lines. Disputes therefore concern whether the requirements were met, not whether the taxpayer chose the treatment (Chapter 54).