Are Contracts Exchangeable?

The “Contract Question” provides more questions than answers...

In certain areas of the country, real estate prices have been skyrocketing. It is not uncommon to see properties double in price over the course of a year -- even before the builder has completed construction! This phenomena has created a situation we are seeing more and more in the 1031 exchange business. Many investors are getting property under contract (pre-construction) and selling that contract prior to closing on the purchase at a substantial profit. In this situation, can they perform 1031 exchange?

As an example, Ivan Investor sees a new condominium development planned for completion in about a year and a half. Ivan plans to buy a unit and rent it out once it is completed. So, Ivan gets a unit under contract for a purchase price of $300,00

A year later--but six months before completion--that unit is now worth $400,000. Ivan has made a $100,000 profit! At this point, Vinny Vacationer comes along and also wants to buy a unit in the development. Ivan and Vinny enter into an agreement whereby Vinny gets the right to purchase the property for $300,000, and Ivan gets $100,000 for selling the contract. The method of conveying this right is called an "assignment." So, Ivan gives Vinny the assignment and waits for the closing to happen in six months when he will get his $100,000. In most cases, Ivan will be paid when Vinny closes on the purchase. This way Vinny can finance the full purchase price of $400,000 at one time.

So, Ivan has made a $100,000 profit on the sale of his contract. An excellent investment by any standard! But, can he perform a 1031 exchange and defer his taxes? The answer is maybe -- but it is very risky! Let me explain.

Unfortunately, there is very little authority on this topic and what little authority there is, often conflicts. Any marginally relevant authority relates to whether an "option" is an exchangeable asset. Most (though not all) authority indicates that an option is a real property interest -- and hence exchangeable.

So, if an option to purchase real estate is considered real property, is a contract to purchase real estate an "option?" Maybe. An option is typically a right that a buyer can purchase that gives him the right, but not obligation, to buy the property upon set terms at a future date. A real estate contract burdens the buyer with the obligation to buy the property upon set terms at a future date. They sound very similar, but there's not much authority on this distinction. Also, what does "like-kind" mean in this context? Remember that in a 1031 exchange, you must buy New Property that is like-kind to the Old Property. So, does that mean when you sell a real estate contract you can buy any real estate, or do you have to buy another real estate contract? What about the equal or up requirement? To defer all of your taxes, you must buy property that is equal to or greater than what was sold. But, what was the value of the sale? $100,000 or $400,000? There are no clear answers to these questions.

Other problems arise in the more mechanical operations of a 1031 exchange. The 45- and 180-day deadlines begin when the "taxpayer transfers the property relinquished." Well, when does this transfer occur? The answer might be that it occurs on the date that Ivan gives Vinny the assignment. But, what about the $100,000 of proceeds that won't be given to Ivan for six months? Also, we have seen these transactions structured without an assignment, but a transfer agreement coupled with a termination of the original contract. This is particularly dangerous for a 1031, because there is no apparent conveyance of real property -- the IRS could interpret it as a contract payment or even a commission.

The bottom-line is that a lot of people are doing 1031 exchanges on real estate contracts despite the potential problems. But there are a number of practical considerations that will give your real estate contract 1031 exchange the best chance of surviving IRS scrutiny.