The “like-kind exchange” rules housed in Internal Revenue Code Section 1031 allow taxpayers to defer gain on the sale of a business or investment property if they reinvest in a similar property within a specified time. Many transactions qualify, and regardless of complexity or size, qualifying exchanges have the same effect: deferral of taxable gain or loss, and deferral of related taxes.
The popularity of §1031 transactions dropped in 2008 when the economy and property values dropped, because there were not many taxable gains to shield and sellers did not care to tie up proceeds in more real estate. In recent years, however, the improved market and economy, coupled with higher taxes, have generated more interest in these transactions.
Several requirements must be met for properties to take part in a like-kind exchange:
- Both the acquired and relinquished properties must be used for investment or business purposes. Personal assets, like primary residences, do not qualify. Example – A taxpayer can exchange a commercial warehouse for a residential property as long as the taxpayer rents out the property rather than using it as a personal residence.
- Properties exchanged must be “like-kind.” The definition is quite liberal when applied to real estate. Example - Vacant land is like-kind to a developed commercial or residential rental property. The guidelines involving property other than real estate are much stricter, and require that the items share the same depreciable asset class. Example – An office filing cabinet may be exchanged for a desk, but not for a computer.
- Certain assets are prohibited. Foreign assets, corporate stock or partnership interests do not qualify.
Mechanical requirements and alternatives
The simplest form of §1031 transaction is the simultaneous exchange: Taxpayer A swaps asset A with Taxpayer B in exchange for asset B. This is most commonly encountered with the trade-in of one business automobile toward the purchase of another.
Outside of an automobile trade, it is uncommon to find two parties, each willing to trade for the other person’s property. Those taxpayers will need to engage a qualified intermediary (QI) to facilitate a delayed exchange.
Delayed exchanges provide the taxpayer up to 180 days from the sale date to acquire a suitable replacement property. The qualified intermediary holds the cash during this time on the taxpayer’s behalf; leaving the taxpayer to merely relinquish one property and take ownership of another. If the taxpayer received cash, even for an instant, it would cause at least some part of the gain to be immediately taxable. Note that to defer 100% of the gain, receipt of non-qualifying property, called “boot,” cannot accompany the exchange property. To avoid boot (which includes cash), the replacement property’s value must exceed that of the relinquished property. Perfect matching is uncommon, so taxpayers generally seek like-kind exchanges when “trading up.” However, the presence of boot does not prevent application of §1031, it merely results in partial deferral.
An example of a delayed exchange - Taxpayer A sells rental property with a tax basis of $500,000 for $2,000,000 on February 1st to Company B. The proceeds are received and held by a QI on A’s behalf. On July 1st, Taxpayer A purchases a parking garage from Company C for $3,000,000. The cash for the July 1st close comes in the form of $2,000,000 from the QI and a $1,000,000 Mortgage. Taxpayer A recognizes no taxable gain on the transaction and has a tax basis of $1,500,000 in the parking garage. The gain is deferred (but not eliminated) by assigning a basis that is lower than the purchase price.
- There is no limit to the number of properties allowed to be relinquished or acquired as part of the exchange.
- Nearly all real estate is considered like-kind to other real estate – including properties located in different states.
Given the complexity of §1031, parties considering such a transaction should discuss their plans with a CPA, tax attorney or other knowledgeable person as early in the process as possible, to make sure the many criteria are met. For those who qualify under any of a number of scenarios, savings through tax deferral are available simply if they are willing to plan.
S. Andrew Smith is a Tax Principal at Baker Newman Noyes specializing in closely held business and real estate transactions. He has advised on numerous Section 1031 transactions. If you think a like-kind exchange is something that could benefit you, please contact Andy at email@example.com.