In most situations when a taxpayer disposes of property, taxes must be paid on any gain at the time of sale. However, if a taxpayer exchanges business or investment property solely for other business or investment property similar to the one originally held, that is of a “like-kind,” section 1031 provides that no gain or loss will be recognized.
If as part of the exchange, the taxpayer also receives other property or money (i.e., non-like-kind), gain must be recognized on the exchange to the extent of the other property and money received. It is important to note that in the event that there are losses, these are not recognized.
Who may make a Sec. 1031 exchange?
Any owners of business and investment property—individuals, C corporations, S corporations, partnerships, limited liability companies, trusts, and any other taxpaying entity—may participate in a Sec 1031 exchange.
To qualify under Sec. 1031, both the property given up and the property received must meet certain requirements. Both properties must be held for use in a trade or business or for investment.
Properties are of a like-kind if they are of the same nature or character, even if they differ in grade or quality. Most real estate will be considered like-kind to other real estate, regardless of its’ state; for example, improved real property and unimproved real property. Therefore, a lot with an office building is of a like-kind to a vacant lot. However, real property in the United States and real property outside the United States are not considered to be of like-kind.
Personal property of a like class are like-kind properties; however, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not considered like-kind.
It is important to note that the rules pertaining to what qualifies as like-kind personal property are much more restrictive than those relating to real property, an example of this can be seen where cars are not considered like-kind to bikes.
Both real property and personal property can qualify for like-kind exchanges, but real property cannot be considered a like-kind to personal property, it’s just a case where we have to compare apples with apples.
Exclusions. Under 1031 exchange, certain types of property are not eligible for like-kind treatment:
· Inventory or stock in trade;
· Stocks, bonds, or notes;
· Other securities or debts;
· Partnership interests; and
· Certificates of trust.
Time is of the essence.
Like in most things, time is of the essence in a 1031 exchange. While it is not imperative that there be a simultaneous swap of properties, in a 1031 exchange you must meet two-time lines or the entire gain on the transaction will be taxable. These time limits are hard limits and cannot be extended in any circumstances except for situations in which a presidential disaster is declared.
· The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties.
· The second limit is that the exchange be completed no later than 180 days after the sale of the exchanged property or the income tax return due date in the year the relinquished property was sold (whichever is earliest). The replacement property received must be substantially the same as property identified within the 45-day limit described in the first limiting factor.
Assumption of liabilities
If the relinquished property is subject to a liability, or any of the taxpayer’s liabilities are assumed, the net aggregate amount of those liabilities is treated as cash received in the exchange. Consequently, if the taxpayer transfers relinquished property subject to a liability, the taxpayer will have gain realized on the transaction to the extent of the lesser of the gain realized or the amount of the liability to which the relinquished property is subject.
Special rules determine the amount of boot a taxpayer receives when each party to a like-kind exchange assumes a liability of the other party, depending on whether any net consideration was received as a result of the difference in the liabilities exchanged and whether any cash (or other non-like-kind property) changed hands to account for a difference in the net values of the exchanged properties. If a taxpayer is deemed to receive net consideration on the liabilities (i.e., the liabilities the taxpayer gives up are more than the liabilities received), the boot is equal to the amount of that net consideration plus the amount of any cash received (or minus the amount of any cash paid) to account for a difference in the net values of the exchanged properties.
If a taxpayer is deemed to pay net consideration on the liabilities (i.e., the liabilities given up are less than the liabilities received) and the taxpayer receives cash from the other party to account for this difference in the net property values, the boot is the amount of cash received. If a taxpayer is deemed to pay net consideration on the liabilities and also pays cash to the other party to account for a difference in net property values, the taxpayer does not have any boot.
Structures of a 1031 exchange
To accomplish a Sec. 1031 exchange, there obviously must be an exchange of properties. The simplest way this can be achieve is by having a simultaneous exchange of one property for another. However, deferred exchanges and reverse exchanges may also be used even though they are more complex, they offer a great deal of flexibility.
A deferred exchange occurs when the property received in an exchange is received after the transfer of the property given up, allowing a taxpayer to dispose of property and subsequently acquire like-kind replacement property.
A deferred exchange is different than the case of a taxpayer simply selling one property and using the proceeds to purchase another piece of property; this transaction would be taxable. In a deferred exchange, the disposition of the relinquished property (and the acquisition of the replacement property) must be mutually dependent parts of one integrated transaction. Taxpayers that engage in deferred exchanges usually use qualified intermediaries (QIs) under written exchange agreements.
A reverse exchange is done whereby the replacement property is acquired before the relinquished property is transferred. The acquired property is literally “parked” for no more than 180 before disposing of the relinquished property.
Restrictions for deferred and reverse exchanges
Please note that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from considered a like-kind exchange and make all gain immediately taxable.
If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property.
Using a qualified intermediary or other exchange facilitator is one way to avoid premature receipt of cash or other proceeds until the exchange is completed. You or your agent can not act as your own facilitator.
Computing the basis in the new property
In-order to comply with section 1031 rules, it is vital that the basis of the property be adjusted and tracked. This is due to the fact that gains are merely deferred and not forgiven. The basis of the property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction.
When the replacement property is ultimately sold not as part of another exchange, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Reporting Sec. 1031 exchanges
A taxpayer is required to report a Section 1031 exchange to the IRS on Form 8824, Like-Kind Exchanges. This form is filed with the taxpayer’s tax return for the year in which the exchange took place.
Requirement for Form 8824:
· Descriptions of the properties exchanged;
· The dates on which the properties were identified and transferred;
· A disclosure of any relationship between the parties to the exchange;
· The value of the like-kind and any other property received;
· Any gain or loss on the sale of other (non-like-kind) property given up;
· Any cash received or paid, or any liabilities relieved or assumed; and
· The adjusted basis of the like-kind property given up and any realized gain.
If the rules for like-kind exchanges are not followed, a tax payer may be held liable for taxes, penalties, and interest on your transactions.
User | 13/12/2017