Section 1031 Like-Kind Exchanges: When They Are the Right Choice
In very simple terms, a like-kind exchange is a tax-deferred transaction that allows one asset to be swapped with another, similar asset without generating a capital gains tax liability from the sale of the first asset. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), the IRS permitted the exchange of certain personal property, intellectual property, and intangible property as long as that property was then exchanged for other personal property. The TCJA narrowed the scope of Internal Revenue Code Section 1031 like-kind exchanges to the exchange of real property that is of the same nature and character, even if it differs in grade or quality. It defined real property as "land and improvements to land, unsevered natural products of land, and water and air space superjacent to land."
Primary residences, inventory, corporation common stock, and indebtedness or notes are specifically excluded from Section 1031 like-kind exchanges. In addition, exchanges of machinery, equipment, intellectual property, intangible business assets, etc., generally do not qualify as real property exchanges. Exceptions to this rule include certain exchanges of stock in mutual ditch, reservoir, or irrigation companies.
The result is that any personal property transferred in a Section 1031 like-kind exchange is treated as if it were bought and sold in separate transactions, and any capital gains on the sale cannot be deferred. Practically speaking, this means every distinct asset included in the exchange must be analyzed separately from every other asset to determine whether it meets this definition.
As might be expected, the rules are complex. A qualifying exchange must adhere to the following rules:
- Both properties must be in the United States.
- The taxpayer has 45 days from the date when the sale of the relinquished property closes to identify a potential replacement property and 180 days to acquire that property. The two periods run concurrently, which means the maximum time period for the exchange to be completed is 180 days, not 225 days.
- In an exchange in which the seller does not acquire the new property at the same time he or she relinquishes the old one, sometimes called a delayed exchange, the "seller" of the first property cannot hold the cash until the new property is acquired. A neutral third party, called a qualified intermediary (QI), facilitates the deal. Relatives and any people who have been your agents or employees in the two years preceding the sale of the relinquished property cannot serve as the QI.
- There is no limit to the number of exchanges a taxpayer can make. As long as the laws and regulations are followed, taxpayers can make even sequential like-kind exchanges.
- Federal law defines what constitutes real property for purposes of a like-kind exchange, but state laws mandate how states tax the sale. This may prove important when the sold property is in one state and the purchased property is in another.
- Depending on the properties being exchanged, any previously claimed depreciation may be recaptured and taxed as ordinary income.
- Any cash left over after the property is exchanged may be taxed as partial sales proceeds. This includes monies from a decrease in liabilities or a change in the amount of a mortgage. Usually, such amounts are taxed as capital gains.
- Taxpayers claiming a like-kind exchange must file Form 8824 for the year in which the exchange occurs.
- New legislation is being discussed that may make this strategy less attractive. Anyone considering a like-kind exchange should carefully monitor developments regarding potential federal tax reform.
Section 1031 like-kind exchanges can be an excellent way to discharge appreciated property that would generate a high capital gains tax if it were sold. It may also be the best choice in other circumstances, such as if the property would otherwise have been sold at a loss.
This is just of summary of a series of complex provisions. If you think a Section 1031 like-kind exchange is right for you, contact us for advice from the start.
About this Author
Nate is a trusted advisor for businesses and individuals, providing tax planning, compliance support, and accounting services. He also is certified as a Personal Financial Specialist which allows him to guide clients through the many challenges and phases of their career from start-up to retirement.