If you invest in real estate, a “like-kind” exchange (also known as a 1031 exchange) is a powerful tool to defer having to pay capital gains taxes for essentially “trading” your investment real estate up for a similar investment property of similar or greater value. Ordinarily, if you purchase property and later sell it for a gain, you may have to pay taxes on the difference. For example, if you purchase a commercial building in your business for $150,000.00 and sell it two years later for $200,000.00, you would have to pay capital gains taxes on the $50,000.00 gain. However, if you sold that same building for $200,000.00 and immediately applied the sale proceeds to purchase a different investment property for $250,000.00, then the capital gains taxes owed are deferred. This exchange is useful for investors wanting to dispose of assets in one location to instead purchase assets in another location without IRS consequences.
Since the Tax Cuts and Jobs Act of 2017 took effect, like-kind exchanges ONLY apply to real estate being exchanged for other real estate in tax years 2018 and later. “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” 26 U.S.C. §1031(a)(1). However, like-kind exchange rules do “not apply to any exchange of real property held primarily for sale.” 26 U.S.C. §1031(a)(2). In addition, real property located in the United States and real property located outside of the United States are not considered like-kind. 26 U.S.C. §1031(h).
You can exchange any real property for almost any other type of real property. “The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.” 26 CFR §1.1031(a)-1(b). For example, “[n]o gain or loss is recognized if… a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 year or more to run for real estate, or exchanges improved real estate for unimproved real estate; or a taxpayer exchanges investment property and cash for investment property of a like kind.” 26 CFR §1.1031(a)-1(c). So, a 1031 exchange would be allowed if a restaurant is exchanged for a duplex, if an apartment building is exchanged for a vacation rental, or a single-family home is exchanged for a hotel. The only real limitation is that the properties MUST be held for productive use in a trade or business OR for investment AND both properties must be located in the United States. 1031 exchanges involving personal property, such as the taxpayer’s main residence, are NOT allowed.
A 1031 exchange can be a simultaneous exchange where the properties are merely traded. However, a 1031 exchange can also be a delayed exchange, meaning that the taxpayer sells the first real property but then uses the sale proceeds to purchase the second real property later on to complete the exchange. However, the following rules must be observed.
- The property to be received in the exchange must be identified within 45 days after the date on which the taxpayer transfers the property relinquished in the exchange. 26 U.S.C. §1031(a)(3)(A). The taxpayer may identify more than one replacement property during this period, but the maximum number of replacement properties that the taxpayer may identify is:
- Three properties without regard to the fair market values of the properties (the “3-property rule”). 26 CFR §1.1031(k)-1(c)(4)(i)(A); or
- Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer (the “200-percent rule”). 26 CFR §1.1031(k)-1(c)(4)(i)(B).
- The property is received within the EARLIER OF 180 days after the date on which the taxpayer transfers the property relinquished in the exchange OR the due date (including extensions) for the transferor’s income tax return. 26 U.S.C. §1031(a)(3)(A). The identified replacement property is considered received within 180 days if:
- The taxpayer receives the replacement property before the end of the exchange period (26 CFR §1.1031(k)-1(d)(1)(i)), AND
- The replacement property received is substantially the same property as identified. (26 CFR §1.1031(k)-1(d)(1)(ii)).
A transfer of relinquished property in a deferred 1031 exchange will not fail merely because the replacement property is not in existence or is being produced at the time the property is identified. 26 CFR §1.1031(k)-1(e)(1). For example, the replacement real estate may be constructed or improved during the 180 days before the deferred exchange must be final. The tax deferred dollars from liquidating the first property can be used to build or enhance the second property while it remains in the hands of a qualified intermediary (taxpayer does not yet possess the property until it is transferred to him by the qualified intermediary). However, the following rules must be satisfied:
- The replacement property must still be identified with 45 days, meaning that the legal description of the land and as much detail regarding construction of the improvements as practicable must be identified. 26 CFR §1.1031(k)-1(e)(2).
- The taxpayer must actually receive “substantially the same property” that they identified before the 45 days expired. 26 CFR §1.1031(k)-1(e)(3).
- The positive equity from the exchange (e.g. difference in value from first property to replacement property) must be spent 100% on improvements to get the full tax deferral and the improvements must be completed before the 180 days has expired.
1031 Exchanges do not have to be limited to two parties and two properties. For example, a taxpayer can exchange one property for multiple replacement properties or multiple properties for one replacement property. The multiple properties acquired can be from different owners and the taxpayer can utilize an intermediary. These 1031 exchanges with multiple parties are also called “Starker Exchanges”, permitted under federal law from the case Starker v. United States, 602 F.2d 1341 (9th Cir. 1979).
To receive the full benefit of the like-kind exchange to get 100% tax deferral, the property being received in the exchange must be worth as much or more than the property being relinquished. If the property being received is worth less than the property being relinquished, then the difference in value is called the “boot” that the taxpayer is liable to pay capital gains tax upon. For example, if the first property is sold for $300,000.00 and the taxpayer buys property for $250,000.00, then the taxpayer will have to pay taxes on the $50,000.00 of gain.
If the taxpayer exchanges property for like-kind property AND other unlike property and/or money, then the taxpayer will have to recognize and pay taxes for any gain attributable on the amount of money received and the fair market value of the other property, but not on the like-kind property received. 26 U.S.C. §1031(b). This arrangement is attractive to sellers who want some of the benefit of a like-kind exchange and some additional cash from the transaction, even if some taxes have to be paid. However, if a taxpayer exchanges property for like-kind property AND other unlike property and/or money but realizes a loss on the deal, the taxpayer will NOT be permitted to recognize any loss on the transaction (e.g. no capital loss deduction). 26 U.S.C. §1031(c).
Property that is acquired via a like-kind exchange will have the same basis to the taxpayer as the property that was relinquished, decreased by the amount of money received in the transaction and adjusted by the gain or loss recognized (if any). 26 U.S.C. §1031(d). If the taxpayer acquired property in a like-kind exchange and also received other additional property, then the basis shall be allocated among the properties received and assigned to the non-like-kind property in an amount equivalent to its fair market value on the date of the exchange. Id.
Special rules apply to like-kind exchanges between “related persons”. Related persons as defined in 26 U.S.C. 267(b) include:
- Members of a family.
- An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual.
- Two corporations which are members of the same controlled group.
- A grantor and a fiduciary of any trust.
- A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts.
- A fiduciary of a trust and a beneficiary of such trust.
- A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts.
- A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust.
- A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual.
- A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership.
- An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation.
- An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation.
- Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.
If a taxpayer makes a 1031 exchange of real property with a related person and, before the date 2 years after the date of the last transfer which was part of such exchange, either the related person disposes of the property or the taxpayer disposes of the property received in the exchange, then then there shall be no nonrecognition of gain or loss as like-kind property. 26 U.S.C. §1031(f)(1). However, the taxpayer or related person will not be punished for the disposition of like-kind property if ANY of the following occurred:
- The disposition of like-kind property is due to the death of the taxpayer or the related person. 26 U.S.C. §1031(f)(2)(A).
- The disposition of like-kind property is due to a compulsory or involuntary conversion IF the exchange occurred before the threat or imminence of such conversion. 26 U.S.C. §1031(f)(2)(B).
- The IRS determines that the exchange or disposition of property did have as one of its principal purposes the avoidance of federal income tax. 26 U.S.C. §1031(f)(2)(C).
The IRS issued Notice 2020-23 on April 9, 2020 in response to the COVID-19 pandemic which provided additional relief to taxpayers. Specifically, any affected taxpayer with a 45-day identification period or a 180-day exchange period under the like-kind exchange rules ending on or after April 1, 2020 and before July 15, 2020 may have until July 15, 2020 to complete the identification or exchange, as applicable (assuming the due date with extensions of the taxpayer’s tax return for the year of the transfer is not before July 15, 2020). Further regulations and rules may be issued as the pandemic continues to rage.
Taxpayers taking advantage of the 1031 exchange tax deferral must file Form 8824 (Like-Kind Exchanges) with the IRS. The rules for like-kind exchanges are complicated and you should consult a tax professional to ensure that you are acting in compliance. Wrongfully claiming a like-kind exchange can lead to an assessment of back taxes, penalties and interest. Even worse, failing to claim a like-kind exchange that you are eligible for can lead to an over-payment on capital gains tax to the IRS that may be too late to get back.
If you have any questions about federal taxation or need further assistance, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC today.