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Proposed Section 1031 Real Property Regulations Contain A Glitch

June 12, 2020

by Monte A. Jackel

The IRS recently proposed regulations relating to the definition of real property for purposes of section 1031. https://www.federalregister.gov/documents/2020/06/12/2020-11530/statutory-limitations-on-like-kind-exchanges. These proposed regulations state that a number of regulations under section 1031 will no longer apply unless the exchange involves a qualifying exchange of real property. Among those listed final regulations are reg. sec. 1.1031(d)-2, dealing with liability relief and assumptions, and reg. sec. 1.1031(j)-1, dealing with exchanges of multiple properties. Regulation sec. 1.1031(d)-2 describes the effects when either or both of the transferred property and the exchanged property are encumbered by debt. The basic gist of these rules is that liabilities on the transferred property count as money received or boot, and liabilities on the exchanged property count as money paid which offsets the boot attributable to liabilities on the transferred property.

The rules under reg. sec. 1.1031(j)-1 relate to an exchange of multiple properties either in the same exchange category or in a different exchange category. These regulations, written before section 1031 was amended to limit its application to real property, generally require the placement of the properties received and transferred into the appropriate exchange group categories, to then net the aggregate liabilities assumed and relieved, apportion the debt and boot to the various exchange categories, and then compute gain or loss realized and recognized.

If the liability on the transferred property includes non-qualifying property, should the portion of the liability attributable to that property count as boot? It would seem that the answer should be no because that transferred property itself is not part of the section 1031 exchange. Conversely, if the liability on an exchanged property is attributable to a property that is not qualifying real property, should that portion of the liability count as money paid? Again, it would seem that the answer should be no.

Under the reg. sec. 1.1031(d)-2 rules, “consideration received …in the form of a transfer subject to a liability …is offset by consideration given in the form of a receipt of property subject to a liability…and by the cash paid…., [but] consideration received in the form of cash or other property is not offset by consideration in the form of an assumption of liabilities or the receipt of property subject to a liability….[but] consideration given in the form of cash or other property is offset against consideration received in the form of an assumption of liabilities or a transfer of property subject to a liability.”

It would seem that the new proposed regulations left out a critical component given the failure to address how the rules under reg. secs. 1.1031(d)-2 and 1.1031(j)-1 should apply in cases where non-qualifying property and qualifying property are part of an exchange and there is also debt encumbering both qualifying and nonqualifying property.