Is there a legitimate way to avoid paying capital gains taxes?
Yes. The benefits of IRS Tax Code Section 1031 can have substantial financial impact for taxpayers. This tax saving provision states:

"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."

What kind of properties qualify for 1031 Protection?
Properties held for investment that could potentially qualify for this treatment include, but are not limited to, real estate, airplanes, automobile fleets, copyrights, art and collectibles. Once a commodity qualifies for 1031 treatment, the basic premise will be to exchange into something that is considered ‘like-kind’ to what is being relinquished. The broadest definition for the threshold of ‘like kind’ is in the area of real estate. Qualifying real property can be exchanged for qualifying real property, regardless of whether the property is raw land, farmland, or holds a 20 unit apartment building. In addition, property held for commercial purposes including retail stores, office condos and shopping centers may qualify.

Properties outside of real estate fall under Personal Property Exchanges. Those items have a much more narrowly defined band of what is considered ‘like-kind’. The two major categories for personal property include asset class and product class. Examples of general asset classes include: office furniture, airplanes, buses, general purpose trucks, barges, etc.

What are the general ‘rules’ of IRS Code Section 1031?
The IRS enacted certain rules, known as safe harbors, that if followed would provide taxpayers highest probability of surviving an audit. Safe harbor rules include:

• The property exchanged must be qualifying property.



• The property use must be qualified, as being held for use in a trade or business, for investment and/or for generating income. Within real estate exchanges, this rule would preclude the following from qualifying:
• Second residences
• Personal residences
• Vacation / Mountain Homes
• Inventory (property held for sole purpose of immediate sale)
• The relinquished property must be like-kind to the replacement property purchased.



• The Safe Harbor time limits must be followed.
• Identification Period.  The taxpayer has 45 days after the first closing to identify property for the second closing. The identification must be made in writing and sent to the intermediary or someone else who is not closely associated with the taxpayer.
• Exchange Period.  The taxpayer has a total of 180 days for the entire exchange period. All properties must be closed within 180 days from the first closing. (Tax filing date could impact full 180 day exchange period.)
• The taxpayer cannot be in receipt of money from the sale.
This rule is a key element of the tax code requirements. The purpose of this rule is fairly simple and is the underlying reason why the IRS permits favorable tax treatment in an exchange. Taxpayers swap properties and show that profits from the sale of one property went directly to the purchase of another, which effectively places the taxpayer in the same financial situation. Therefore, if a taxpayer wants to successfully defend the position that he/she is not financially better off than if he/she had not sold the property, the taxpayer cannot benefit from receiving the proceeds of the sale.
• The transaction must actually qualify as an exchange
An exchange transaction varies from a straight sale and purchase. The IRS requires that neither the taxpayer nor an agent or relative of the taxpayer can enjoy actual or constructive receipt of the proceeds from the sale of the relinquished property. Qualified Intermediaries assist with this crucial step. Following the closing of the relinquished property, if the taxpayer receives proceeds, it is likely the transaction will not be considered an exchange.
• The same taxpayer must be on both legs of the exchange
1031 Tax Deferred Exchange protection is valid only if the identical taxpayers or legal entities are on both sides of the exchange. For example, taxpayers may not sell relinquished property vested in their individual names and take title to the replacement property in the name of a trustee for their revocable living trust.

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Most IRS Section 1031 exchanges involve the sale of real estate and the acquisition of like-kind replacement property. As we have previously noted, property held for investment, income production or use in a business is qualified as like kind with any other property held for investment, income production or use in a business. Fee simple ownership of investment real estate is the most common form of ownership in property involved in exchanges, but other ownership interests may be used as well. Specifically, leasehold interests can be used in exchange transactions, but special rules apply to various situations. These exchanges are not as common as transfers of the fee interest in real property, but leasehold exchanges have been around for a long time and can provide great flexibility for clients when used appropriately with knowledgeable tax advice.

IRS regulations provide that a leasehold interest of 30 years or longer is treated as like kind with fee simple real estate. Subsequent rulings make it clear that optional renewal periods are included in determining the length of the leasehold interest. For example if the lease has a 10-year initial term and 5 five-year options, the length of the lease is 35 years for 1031 exchange purposes. As long as the lease in this example is in the first five years of the term, there will be more than thirty years left and it will be treated as like kind.

For example, a Taxpayer wishes to use an exchange to swap a $250,000 warehouse for an existing lease on a shopping center out-parcel with a value of $275,000. The 20-year lease has two 10-year extensions and is in its ninth year. Therefore, the leasehold length is 31 years (20 years plus two 10-year extensions equals 40 years minus nine years nets 31 years). Taxpayer can sell the warehouse and buy the 45-year leasehold interest as replacement property to complete a successful exchange as long as the exchange is in compliance with all other IRS guidelines.

Short-term leases are not like kind with fee simple real estate. However, they may be considered like kind with other short-term leasehold interests. Although the IRS has approved some short-term leasehold interest exchanges in private letter rulings, it has offered taxpayers no authoritative guidelines on whether the leasehold interests must be similar in term to be considered like kind. For instance, we do not know whether a 5-year leasehold will be considered like kind with a 10-year leasehold.

Taxpayers wishing to construct replacement property improvements on land owned by other parties can use a leasehold in conjunction with an improvement exchange. A successful tax-deferred exchange can be accomplished if the leasehold improvements equal or exceed the value of the relinquished property before the end of the 180-day exchange period. This will require the services of both a QI and an Exchange Accommodation Titleholder. After the relinquished property closing, the EAT enters into the leasehold agreement on the taxpayer's behalf and uses the sale proceeds to construct the improvements. Once the improvements are complete or the 180-day period has ended, the EAT transfers the leasehold interest, which includes the improvements, to the taxpayer via the QI. Of course, the lease term must exceed 30 years as noted above and the identification rules will require a fairly specific description of the state of the improvements if they will not be anticipated to be substantially complete at the end of the exchange period. Valuation issues add complexity to this identification process and should be undertaken only with expert guidance.

Another possibility is where the taxpayer builds leasehold improvements on ground it already owns or controls through a related party. A recent PLR suggests the IRS may allow such transactions if they are carefully structured. PLR 200251008 involved a construction exchange where the party on the other side of the long-term lease was a "related party". What seemed to be a key factor was the existence of a 30-year or longer leasehold interest on the land. This allowed for two different conveyable elements: the underlying fee interest and the leasehold interest. By creating a separate conveyable leasehold interest, the taxpayer increased the value of the leasehold by building improvements that the IRS allowed to be conveyed as the replacement property.

Rev. Proc. 2004-51, issued two years later, was promulgated by the IRS to avoid a situation where a taxpayer conveys property to an accommodator who completes a build-to-suit exchange then conveyed it back as replacement property in an exchange. This makes it clear that we should expect close scrutiny for these exchanges. Therefore, this type of exchange is extremely complicated and requires expert interpretation of a combination of tax and legal issues. Taxpayers must consult tax and legal professionals before attempting this type of transaction.