When appreciated investment property is sold, the investor may be subject to a large tax liability at the time of the sale.
However, the IRS has a special provision (IRC Section 1031) that permits an investor to defer paying tax on a gain if the proceeds are reinvested into a similar property.
A qualified like-kind exchange, or “1031 exchange,” allows property owners to exchange real or personal property (relinquished property) for other property of a like-kind (replacement property) and then defer the gain.
To receive the tax benefit, both the relinquished property and the replacement property must be held for use in a trade, business or for investment, and be of the same nature or character; however, neither the quality nor grade of the property factors into the exchange. Property used primarily for personal use, such as a residence or vacation home, typically does not qualify.
Real property, such as buildings and land, may only be exchanged for real property, while personal property, such as machinery, equipment, business vehicles and the like, may only be exchanged for personal property.
Like-kind personal property exchanges are much more restrictive since the properties must be of the same nature and character. In the United States, most forms of real estate (real property) are considered like-kind. For example, real property such as an improved office building is like-kind to undeveloped land. However, real estate property within the United States is not like-kind to property abroad.
At its simplest form, a like-kind exchange involves a simultaneous swap, where both parties defer the gain of their respective properties sold during this transaction until the new property is disposed of. Another type of exchange, known as a deferred exchange, allows an owner to dispose of one property and then acquire one or more like-kind replacement properties. The sale of the relinquished property and purchase of the replacement property must be interdependent to qualify for 1031 treatment.
For the owner to defer the total gain, the value of the replacement property must be equal to or greater than the value of the relinquished property at the time of the exchange. Often, like-kind exchanges include the property, along with cash, liabilities and property that is not like-kind.
If cash, aka “boot,” relief from debt or property that is not like-kind is involved, a taxable gain may be triggered in the year of the exchange. There can be deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
A like-kind exchange does not require the swap to occur simultaneously, although two strict time restrictions must be met to defer the gains and will not be extended for any circumstance or hardship.
A 45-day identification period must occur first; this requires the seller to identify any and all like-kind replacement property and provide a written declaration signed by the buyer and seller of the replacement property. Next, the owner must acquire the replacement property no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return, whichever comes first.
These 1031 exchanges can be very complex, and failure to follow the IRS rules may exactly make an investor liable for taxes, and possibly penalties and interest. Consulting with qualified tax and legal professionals prior to entering into a like-kind exchange is recommended.
This article was originally published in the April/May 2016 issue of Worth.