Assessing the importance of correctly structuring your

§1031 exchangeIn a §1031 exchange if a taxpayer exchanges their current relinquished property for like-kind replacement property there is no tax consequence resulting from the transaction. Any realized gain is deferred until the sale of the replacement property. However, at the outset of any §1031 exchange, a taxpayer must determine certain issues regarding the transaction. Most notably, whether the properties are eligible for tax-deferred treatment under §1031(a)1, and whether the relinquished and replacement properties are like-kind. In the context of a real estate exchange, taxpayers assume that in order to satisfy requirements of §1031 they must own the underlying relinquished property before initiating the exchange, and also acquire the underlying replacement property to complete the transaction. However, if the taxpayer has a real estate purchase agreement to acquire designated property, the contract itself may be exchanged as part of a §1031 transaction. If structured correctly, the exchange of the real estate purchase agreement can create new exchange opportunities for taxpayers. For example: Assume the taxpayer has entered into a purchase agreement to acquire real estate for $1 million. The taxpayer intends to acquire the property and hold it for investment. However, since the entry into the purchase agreement the value of the real estate has increased to $1.5 million. Prior to closing on the property, the taxpayer is approached by a buyer who offers to acquire taxpayer's rights under the purchase agreement for $500,000. The taxpayer should be able to sell the purchase agreement to the buyer, and use those funds in a §1031 exchange to acquire real estate. The support for this transaction structure can be found in the landmark ruling of Starker v. US, which is the most widely recognized case involving like-kind exchanges. In Starker, the taxpayer exchanged real property for a contractual agreement to acquire designated real estate. The court stated that the transaction qualified for like-kind exchange treatment, affirming that contractual rights are to be treated as like-kind to ownership rights in real property. According to Starker: "...title to real property, like a contract right to purchase real property, is nothing more than a bundle of potential causes of action:..." The bundle of rights associated with ownership are obviously not excluded from §1031; a contractual right to assume the rights of ownership should not, we believe, be treated any different than the ownership rights themselves. The court asserted that the "bundle of rights" associated with ownership of the contractual rights, such as those in a real estate purchase agreement, is properly considered like-kind to other real estate assets and not excluded from §1031. In subsequent decisions, the courts have affirmed the analysis set forth in Starker. Most notably, in Biggs v. Commissioner the court applied a substance over form analysis is determining that a transaction in which a purchase contract was exchanged for real property did qualify for §1031. As word of caution, taxpayer's and their advisors should be aware that although the rationale outlined in Starker and Biggs addresses issues regarding the eligibility of the particular asset for a §1031 exchange, other issues must also be met in order for the transaction to qualify for tax-deferred treatment. A particular issue which must be addressed is the qualified use test. The qualified use test states that any asset to be exchanged must be held for either investment or for productive use in a trade or business. For example, many of the most attractive opportunities for the exchange of real estate purchase agreements may occur where taxpayer holds a pre-construction contract on a property that is realizing significant appreciation. If the underlying asset has realized an increase in value above the amount set in the pre-construction contract the taxpayer may be able to transfer his interest in the contract to a buyer for a substantial premium. If the taxpayer can establish that at the time he entered the contract, his intent was to acquire the underlying property and hold it for an investment or business purpose, taxpayer should satisfy the qualified purpose requirement and the sale of the contractual interest should qualify for §1031. However, the IRS has stated that the critical factor in evaluating the taxpayer's intent as to whether the particular asset was held for investment or business use, is the length of time the taxpayer holds the exchange asset. Therefore, if the taxpayer transferred his interest in the pre-construction contract shortly after entering the agreement, the IRS may suspect that the taxpayer entered into the pre-construction contract with the speculative intent to sale his interest in the contract. As such, the service may determine that the taxpayer's intent was merely to resale the asset, rather than to hold the property for investment or business purpose, and the transaction would not meet the qualified use test. Derrick Tharpe, JD, the vice president at Wachovia Exchange Services, Winston-Salem, N.C.