IRS Challenges a State's Definition of "Real Estate..."

A recent Tax Court case could dramatically impact the exchange of 1) pre-construction contracts, and 2) purchase and sale contracts. In the past, it was common for taxpayers to do a 1031 exchange on a contract if their state defined that type of contract as "real estate."

For example, Fred enters into a pre-construction contract to buy a unit in a beachfront development in Florida. Two years later, construction on the building is almost complete. Fred has a buyer who would like to purchase the unit for $100,000 more than he is under contract to pay. If Fred takes title to the unit, he has to wait another year-and-a-day before he can sell it and do a 1031 exchange.

Alternatively, before taking title to the unit, Fred could sell the contract to the buyer and roll his gain into another property in a 1031 exchange. This is because he was under contract for more than a year-and-a-day, and because Florida defines these type of contracts as 'real estate.' That is, until now.

In a recent Tax Court case, the IRS challenged the long-held standard that something defined as "real estate" in one state can be 1031 exchanged for other conventional real estate. Even more disturbing, the court agreed that federal law (meaning what the IRS thinks) trumps state law in these matters.
If you or your clients have been involved in these types of transactions in the past, read this article before you contemplate doing another one like it.

--The Experts