A Section 1031 exchange is a sale of real estate or personal property and the acquisition of a similar real estate or personal property, within certain time limits, that is structured as a tax-deferred exchange. These types of exchanges are also known as “like-kind” exchanges. The exchange gets its name from Section 1031 of the U.S. Internal Revenue Code. The code allows the taxpayer to avoid paying capital gain or depreciation recapture taxes when they have resulted from a like-kind exchange. This memo will cover the various types, qualifying properties, time limits, rules and restrictions of like-kind exchanges.
For a like-kind exchange to exist, an exchange of properties must occur. Section 1031 exchanges only involve an exchange of business or investment properties. Like-kind exchanges can be structured in three different ways. The first structure is when the properties are exchanged simultaneously. This type of exchange is the simplest of the three types and takes place between two parties. The second structure, or a “deferred exchange,” is when a property is disposed of and later one or more properties are acquired that are like-kind to the disposed property. This type of structure can be more complex and takes place between various parties. The third structure, or “reverse exchange,” occurs when a taxpayer acquires replacement property and later the current property is traded. The reverse exchange is the most complex of the three types and can involve various parties similar to a deferred exchange.
To illustrate the like-kind exchange structures, I have provided diagrams of each type of like-kind exchange structure below.
Property A is exchanged for Property B on the same date between two parties.
Property A is sold to an outside party and sale proceeds are acquired. A time period to find a replacement property goes by. The taxpayer transfers the sale proceeds from selling Property A to the seller of Property B to acquire it. This exchange happens between three parties.
Property B is purchased by the taxpayer, which is held by an exchange accommodation titleholder. The taxpayer identifies Property A to sell during a certain time period. Property A sells, and the accommodation titleholder transfers Property B to the taxpayer.
For the exchange of properties to be considered a Section1031 exchange, the properties must meet certain qualifications. The first criterion is that both properties involved in the exchange, whether real or personal, must be used for trade, business or investment purposes. Real property is generally land and buildings. Personal property is tangible or intangible business assets. Good examples of personal property include equipment, livestock or copyrights. The second criterion is that both properties must be like-kind. This expression means that both properties must have a similar character, nature or class. With this said, real property is not like-kind with personal property as the nature, character, and class of both properties is vastly different. In other words, real property may be exchanged with real property, and personal property may be exchanged with personal property to qualify as a like-kind exchange.
Many like-kind exchanges happen as a simultaneous swap, but since not all exchanges are structured as so, it is important to learn about the time restrictions related to like-kind exchanges. Unless one wants their gain to be taxable, a section 1031 exchange must meet two time limits. The first time limit is the taxpayer has 45 days from the sale date to identify potential replacement properties. A written document that clearly states the replacement property or properties must be signed by the taxpayer and delivered in person by a real estate agent to the seller of the replacement property. The second time limit is the exchange must be completed before 180 days from the sale date of the exchanged property, or the due date of the income tax return (including extensions) for the tax year which the exchange property was sold, whichever date comes earlier.
There are a number of rules and restrictions to look out for when dealing with Section 1031 exchanges. Many deferred and reverse exchanges can be complicated, and the rules or restrictions can add to the complexity of each exchange. There are rules for identifying a like-kind property. The time restriction of 45 days was mentioned earlier in the memo, but there are three more rules to take into consideration.
Like-kind exchanges have rules on choosing replacement properties for deferred exchanges. The first rule is the three-property rule. This rule allows the taxpayer to chose three property options regardless of what their market value is. The next rule is the 200 percent rule. This rule allows the taxpayer to chose as many properties as they want as long as the sum of all property values is equal to or less than 200 percent of the sold property. The last property rule is the 95 percent rule. This rule allows the taxpayer to identify as many properties as they want as long as they acquire properties valued 95 percent or more of their total value.
There are also restrictions that taxpayers must pay attention to. Restrictions involving premature receipt of proceeds or cash may interfere with how the exchange is treated. If a taxpayer receives any cash or proceeds before an exchange is completed, the transaction will no longer be treated as a like-kind exchange. In this case, all gain will be taxable. If any cash or proceeds are received at the end of an exchange but are not part of the like-kind exchange property, the gain may be taxable to the extent of the proceeds that are not like-kind property.
Certain parties can hold on to proceeds until an exchange is done. The parties include a qualified intermediary or exchange facilitator. There are restrictions for who the facilitator can be. A taxpayer cannot act as their own facilitator. A taxpayer’s real estate agent, investment banker, accountant, attorney or employee that has worked for them in the past two years cannot act as their facilitator.
In conclusion, understanding Section 1031 exchanges can be very important. Knowing the different types, qualifications, time limits, rules and restrictions may lead a taxpayer into an exchange that can defer their taxes on their capital gain or depreciation recapture. There are benefits to having knowledge about like-kind exchanges, but one has to start with the basics.