LIKE KIND EXCHANGE OR 1031 EXCHANGE (TAX DEFERRED)
A like kind exchange is a method of transferring property that defers the tax impact of the transaction, commonly referred to as “tax deferred exchanges”, or “Section 1031 exchanges”. Sometimes these transactions are called “tax free exchanges”, but this is a misnomer since these exchanges only involve a deferral of tax liability, not an avoidance of tax liability.
BASIC RULES
Certain requirements must be met in order for a transaction to qualify as a like kind exchange. The relevant section of the Internal Revenue Code, Section 1031 (a) has three major requirements for a transaction to qualify as a like kind exchange: (1) the relinquished property must be held for a productive use in a trade or business or for investment; (2) the property must be exchanged for property (the “replacement property”) of like kind which is to be held for productive use in a trade or business or for investment; (3) there must be an exchange.
PROPERTIES EXCHANGED MUST BE OF “LIKE KIND”
This requirement references the nature and character of the property and not the type or quality of the property. It is not required that the relinquished property and the replacement property be the exact same type of property, however, both properties must be held for productive use in a trade or business or for investment. For example, one may sell a drugstore that was held for investment and acquire raw land that will be held for investment. There is no set holding period to determine if a property is a qualifying property. The question of whether a property meets the definition of eligible property is one not determined purely by time. The question is one of intent and circumstances involving a number of factors which have been examined in a number of cases and examples which are beyond the scope of these materials. There are a number of tests set forth in the regulations and related tax cases that give guidance in determining whether a taxpayer’s use of property qualifies for treatment as property held for productive use in a trade or business or for investment.
THERE MUST BE AN EXCHANGE
The mere sale of one property and reinvestment of all of the proceeds in a replacement property will not qualify as an exchange. A straight swap of one property for another property of like kind involving only the properties themselves and no money (or other compensation) changing hands clearly can qualify as an exchange. Since direct swaps of property with no additional compensation (“boot”) are rare, a majority of section 1031 exchanges are “delayed exchanges” or “deferred exchanges” using an exchange agreement with a qualified intermediary and the relinquished property and the replacement property are transferred pursuant to the terms of the exchange agreement.
A delayed or deferred exchange occurs where the taxpayer disposes of the relinquished property at one point in time and acquires the replacement property at some later point in time. Section 1031(a)(3) of the Internal Revenue Code sets forth clear rules for deferred exchanges. In order to qualify as replacement property under this section, the replacement property must be (1) identified by the taxpayer, in writing, to the person obligated to transfer the replacement property to the taxpayer (or someone else involved in the exchange that is not the taxpayer) no later than midnight on the 45th day after the transfer date of the relinquished property (typically the date of recording of the deed transferring the relinquished property); and (2) the replacement property must be received by the taxpayer by the earlier of (a) 180 days after the transfer date of the relinquished property or (b) the due date of the taxpayer’s tax return (including any extensions). If the dates as determined under these time frames fall on a Saturday, Sunday, or legal holiday, the taxpayer is NOT given until the next business day to meet the requirements of the rule.
Since a deferred exchange is not a simultaneous exchange, it is important to make sure that the taxpayer does not actually or constructively receive the proceeds of the sale of the relinquished property in the interim. If actual or constructive receipt by the taxpayer occurs, the exchange is disqualified (even if the taxpayer does acquire a replacement property). For this reason, an exchange agreement typically is entered into by the taxpayer and a qualified intermediary. This exchange agreement will provide that the qualified intermediary hold the proceeds of the sale of the relinquished property and use them, under the terms of the exchange agreement, to acquire the replacement property for the taxpayer. The agreement will also address any other matters related to the structure of the exchange and the parties’ obligations concerning the use of the proceeds of the relinquished property and the acquisition of the replacement property.
Some recent guidance by the IRS has increased the incidence of the use of reverse exchanges and improvement exchanges. A reverse exchange occurs where a taxpayer acquires the replacement property before the sale of the relinquished property. This circumstance may arise where there is a delay in the closing of the sale of the relinquished property or where the taxpayer finds a replacement property that market circumstances require immediate action to secure. Improvement exchanges involve exactly what the name implies-exchanges where the replacement property is either to be built or renovated or expanded. There are no black and white rules regarding these types of exchanges and discussion of them in detail is outside the scope of this document.
In addition, tenancy in common interests in real property are increasingly being offered in the marketplace as investments or as replacement property for exchanging taxpayers. These offerings provide partial ownership of a property and often involve larger or more valuable properties than an individual investor could afford on their own. These offerings also typically involve a property which has nationally recognized or strong credit tenants. The benefit to investors is stated to be the ability to own a part of a quality property with a strong tenant or tenants. A detailed discussion of these investments vehicles is outside the scope of this document.
WHAT IS THE BENEFIT OF A 1031 EXCHANGE?
Sales of real property are subject to tax, most often at capital gains rates. The benefit of a Section 1031 exchange is that the tax is deferred because, under the IRS regulations, no gain or loss shall be recognized in an exchange completed in accordance with the section. If a taxpayer is facing a significant gain on a sale of a piece of real property, they may be able to benefit from a tax deferred exchange. If a taxpayer wants to totally defer tax liability using a Section 1031 exchange, the taxpayer must acquire replacement property with a value that equals or exceeds the value of the relinquished property, and all the proceeds from the sale of the relinquished property must be used to obtain the replacement property. If there was debt on the relinquished property, there must be at least as much debt on the new property (or the taxpayer must inject new money equal to the difference between the debt on the relinquished property and the debt on the replacement property). If the transaction does not meet these requirements, it may still be possible to qualify for partial non-recognition of gain under Section 1031(b).
A proper analysis of the tax consequences of a like kind exchange involves determining the taxpayer’s realized gain or loss, determining the taxpayer’s recognized gain (boot) and any offsets that there may be to this recognized gain, as well as determining the basis of the replacement property (since an exchange requires the transfer of basis from the relinquished property to the replacement property so that tax liability may be ultimately captured).
REAL ESTATE AGENTS ARE ESPECIALLY CAUTIONED NOT TO GIVE ADVICE REGARDING THE ELIGIBILITY OF PROPERTY FOR A SECTION 1031 EXCHANGE OR HOW TO CONDUCT SUCH AN EXCHANGE. WHILE AN AGENT MAY SUGGEST THAT A CLIENT CONSIDER AN EXCHANGE, THE CLIENT SHOULD BE DIRECTED TO CONSULT WITH THEIR TAX ADVISOR OR AN ATTORNEY WITH EXPERIENCED IN HANDLING SUCH EXCHANGES
