Typically, in business when the decision is made to replace an asset or investment, one simply sells the asset and purchases a new one. This transaction creates a potential taxable gain on the sale and thus could create a current tax liability. However, if the plan is to replace the asset disposed of with a similar asset it may be wise to consider a Section 1031 Like-Kind Exchange. However, the Tax Cuts and Jobs Act (TCJA) reduces the types of property eligible for this favorable tax treatment.
Like-kind exchange tax treatment is now generally limited to exchanges of real property. Effective 1/1/18, exchanges of personal or intangible property such as machinery, equipment, vehicles, artwork, collectibles, and intellectual property generally no longer qualify for nonrecognition of gain as like-kind exchanges. Like-kind exchange treatment now applies only to exchanges of real property held for use in a trade or business or for investment. Real property includes land and generally anything built on or attached to it.
What is a Like-Kind Exchange?
- A Section 1031 Like-Kind Exchange does not provide the taxpayer the ability to avoid recognizing a gain and any tax owed, but it allows the gain and tax to be deferred until the asset received in the exchange is later sold.
- A Section 1031 Like-Kind Exchange is reported on Form 8824 and filed with the taxpayer’s tax return for the year in which the exchange occurred.
Real property and personal property used in a business or held for investment can both qualify as an exchange, however real property cannot be exchanged for personal property and vice versa. The tax benefit of an exchange is that you defer tax and, thereby, have use of the tax savings until you sell the replacement property. An example of a real property exchange would be an individual with rental properties. Instead of selling rental properties and buying new rental properties, one could simply exchange them for different properties and defer any potential taxes until they finally decide to sell off the rental properties received in the exchange.
What Changed Under the TCJA?
The TCJA didn’t eliminate like-kind exchanges and still generally allows tax-deferred like-kind exchanges of business and investment real estate. However, the TCJA eliminated tax-deferred like-kind exchange treatment for exchanges of personal property that includes everything from equipment, cars, trucks, etc., after December 31, 2017. Prior-law rules that allow like-kind exchanges of personal property only apply if part of the exchange was completed by December 31, 2017, even when part of the exchange remained open on that date. Overall the Section 1031 exchange rules have not changed since 1984.
Section 1031 Like-Kind Exchange Requirements
While a Section 1031 exchange may be of great benefit to the taxpayer, be warned there are stringent requirements involved in the exchange to qualify. Below are some of the major areas of concern involved in the process.
Step one in the process is to identify both the property the taxpayer wishes to relinquish and the property to be received. To qualify as a Section 1031 exchange, the property being exchanged must be held for use in a trade or business or for investment. Personal use property, such as a primary residence, vacation home or personal vehicle, does not qualify for like-kind exchanges. Furthermore, below is a list of property specifically excluded from Section 1031 exchange treatment:
- Inventory, stock in trade, or other property held primarily for sale
- Stocks, Bonds, or Notes
- Other securities or debt
- Partnership interests
- Certificates of Trust
In addition, the property must be similar enough to qualify as “like-kind” property. Like-kind property is property with the same nature, character, or class, but the quality or grade of the property does not matter. For example, a rental property such as an apartment complex could be exchanged for land, a strip shopping mall, or a commercial office building, etc. With respect to real estate, it is important to note that property that is within the United States is not considered to be like-kind with property outside of the United States.
There are two-time requirements involved in a Section 1031 exchange and both requirements must be met or the entire gain will be taxable. The first requirement is that the property to be received in the exchange must be identified within 45 days after the date on which the property the taxpayer is exchanging is relinquished. The identification of the replacement property is required to be in a signed written document and must be delivered to the person obligated to transfer the replacement property or to a qualified intermediary.
Multiple properties can be given up in an exchange and can be exchanged on different dates. However, please note that the exchange period begins on the date of the earliest transfer. Also, multiple properties can be identified as replacement property. No matter how many properties are given up the taxpayer is only allowed to identify three replacement properties regardless of their fair market value or any number of properties so long as the fair market value of all the properties is not more than double the total fair market value of the properties given up on the date of transfer.
The second-time requirement states that the property received must be received and the exchange completed by the earlier of the 180th day after the date the property given up was exchanged or the due date, including extensions, for the taxpayer’s tax return for the tax year that the property given up was exchanged. The timing of receipt is critical to making a Section 1031 exchange work and must be followed carefully. If money or any unlike property is or constructively received in full consideration of the property transferred prior to receiving the identified property, the transaction will then be treated as a sale rather than a deferred exchange. Furthermore, if money or unlike property is received in less than full consideration of the property transferred prior to receiving the replacement property, the transaction will be treated as a partial taxable exchange.
Qualified Intermediary (QI)
To properly execute the exchange, one must be very careful in the actual exchanging of properties and the receipt of property or money. Sometimes an exchange will occur as a simultaneous exchange of properties, but an exchange can also consist of selling the property and using those proceeds to then purchase a replacement property. The taxpayer cannot act as their own facilitator, but rather a qualified intermediary (“QI”) is used to facilitate the exchange.
A QI is a third party that acts as a middleman in the transaction wherein the QI acquires the property given up by the taxpayer, transfers that property, acquires the replacement property and then transfers the replacement property to the taxpayer. A QI is defined as a person who is not the taxpayer or an agent of the taxpayer that enters a written agreement known as an exchange agreement with the taxpayer. In order to qualify as a QI, they must not meet any of the below:
- The taxpayer’s agent at the time of the transaction – An agent is anyone who has acted as the taxpayer’s employee, investment broker, attorney, accountant or real estate agent within the 2-year period ending on the date of the transfer of the first relinquished property
- A person related to the taxpayer
- A person that is related to the taxpayer’s agent at the time of the transaction
In a situation where the property given up is sold and the proceeds are then used to replace the property, the entity that receives the cash or proceeds on the sale becomes very important in making the exchange work. A qualified escrow account or a qualified trust can be used to receive and hold the cash or cash equivalent that will be received on the initial exchange and thus used to purchase the replacement property. Both types of accounts are similar in that the taxpayer cannot be the escrow holder or trustee and an agreement must exist that expressly limits the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefits of the cash or cash equivalent held by the account. Very simply put, if the taxpayer can access, use, or actually receives the cash or equivalent it will cause the entire transaction to be treated as if it were a sale and it will be considered a taxable event.
Section 1031 Exchanges between Related Parties
An exchange is allowed between related parties, however additional requirements must be met to qualify it as a deferred exchange. In a related party transaction if either party disposes of the property received within two years after the exchange, the gain or loss of the original transaction must be recognized as of the date of the later disposition. A related party includes ancestors, siblings, and lineal descendants.
Basis of Replacement Property
One of the last issues to consider in a Section 1031 exchange deals with the basis of the new property. Any tax that would have been owed on the disposition of the property is deferred not avoided. Thus, correctly calculating and tracking basis of new property becomes very important. The basis of the new property will have the basis of the property given up plus or minus certain adjustments. Any costs incurred by the taxpayer or gain recognized will increase the basis of the received property. Basis will likewise be reduced by the amount of money received or any loss recognized on the exchange.
An important thought to remember when dealing with like-kind exchanges is that rarely will the exchange occur with items of the exact value. Many transactions may involve cash or other boot and will also consist of liabilities being passed from one to the other. These items will not cause the exchange to be disqualified completely, but will instead trigger a partial taxable event on the unlike property received. If you receive cash or the other party assumes a liability of yours, then the total of unlike property received less exchange expenses paid will be your recognized gain on the transaction.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.