IRS Challenges State's Definition of Real Estate in a 1031 Exchange

One of the basic concepts of a 1031 exchange is if something qualifies as “real estate” under state law, it qualifies as “real estate” for purposes of a 1031 exchange. For example, several years ago we were involved in an exchange of an oil and gas pipeline that crossed several states. Whether or not that pipeline was considered real estate depended on the laws of each state. As a result, we ended up with a situation where the portion of the pipeline in one state was classified as real estate, even though it was above ground, while another section of pipeline in another state was NOT considered real estate, even though it was buried in the ground.

In a recently released court case, the IRS challenged a state’s characterization of a property. This is the first time I’ve seen them do this, and it causes me some concern with how some types of exchanges are handled in Colorado.

...This is the first time I’ve seen them do this, and it causes me some concern...

In the case, Peabody Natural Resources Company, et al. v. Commissioner, Peabody exchanged gold mines for coal mines owned by Santa Fe Pacific Mining Corp. Included with the coal mines it received were some supply contracts that obligated them to supply coal to Tucson Electric Power. Under New Mexico law, where the mines are located, these types of contracts are considered real estate. So Peabody treated them as such in its exchange. The IRS disagreed, arguing that “the status of the supply contracts, for purposes of section 1031, is a question of Federal tax law.” If the IRS was correct, Peabody would not have purchased enough replacement property, and would therefore have had taxable gain in its exchange.

Peabody ultimately won this challenge because the court decided that the supply contracts were real estate. During their discussion of the supply contract issue, the court made the statement that “their status under New Mexico law was not determinative” of whether they constitute like-kind property under section 1031, and the court went on to rule in Peabody’s favor on other grounds.

As one who tries to guide clients through the mine-field of section 1031, I find the courts comments disturbing in regards to two situations that are fairly common in Colorado exchanges.

The first situation involves Colorado water rights. Many of the water rights we see are not attached to a particular piece of land, but are represented by a certain number of shares in a local ditch company. Colorado law, and common exchange practice, says that these water rights are considered real estate owned by the holder of the shares in the ditch company. The Peabody case could create a problem if an IRS agent decided that they were water rights securities rather than real estate. While I think such a challenge by the IRS is remote, it is something to think about.

The other situation, which worries me more, involves purchase contracts and pre-construction contracts. By a purchase contract I simply mean a contract to buy a certain piece of property. A pre-construction contract, on the other hand, means that you agree to buy a property when the construction of improvements on that property is finally completed.

Under Colorado law, these types of contracts are considered real estate, and the common practice in the exchange community is if you are under contract for at least a year-and-a-day, you can sell the contract (assuming the seller will let you) and do a 1031 exchange into a fee simple interest in another piece of real estate.

For example, Fred enters into a purchase contract to buy the property at 123 Main Street in Denver, with the closing to take place within 30 days of the property being rezoned from single family to multi-family. Two years go by and the rezoning is finally approved, greatly increasing the value of the property. If Fred closes on the purchase and takes title to the property, his year-and-a-day holding period for his exchange starts all over again. However, as the theory goes, since he’s been under contract for more than a year-and-a-day, he could sell his rights under the contract before he takes title to the land and roll the gain through a 1031 exchange into another property.

As I read the Peabody case, the IRS is saying they no longer feel bound by state law in determining if a transaction meets the requirements of section 1031. Apparently the court agrees with them. My advice: be cautious in approaching an exchange of water rights. Make sure you cover all your bases when you exchange a contract.