When real estate or other appreciated business assets are sold, you generally must pay tax on the appreciation. Section 1031 offers one way to defer this tax: a “like kind” exchange. Unfortunately, the Tax Cuts and Jobs Act (TCJA) cuts down on the kinds of property that qualify for this favorable tax treatment.
What is a like-kind exchange?
The Internal Revenue Code, Section 1031, permits the deferral of real or personal property gains from assets used in a business or held for investment, if you trade it (rather than sell it) for property of “like kind.” The tax benefit of an exchange, therefore, is that you put off the owed tax and can use the tax savings up to the sale of the replacement property.
Where real estate is concerned, this method is especially flexible. Practically any type of real estate will be regarded as like kind, providing it’s business or investment property. For instance, you could exchange a strip mall for an apartment complex or a warehouse for an office building.
Deferred and reverse exchanges
It might sound as if a like-kind exchange were quick and easy, but it’s quite rare for two owners to simply switch properties. You will probably have to perform a “deferred” exchange, where a qualified intermediary (QI) facilitates.
When you sell your property (the relinquished property), the net proceeds go directly to the QI, who then uses them to buy replacement property. Typically, in order to qualify for tax-deferred exchange treatment, you have to identify replacement property within 45 days after you transfer the relinquished property and complete the purchase within 180 days after the initial transfer.
Another option would be to conduct a “reverse” exchange. In this situation, before you sell the original property, an exchange accommodation titleholder (EAT) procures title to the replacement property. To defer capital gains in this manner, you must identify one or more properties to exchange within 45 days after the EAT obtains the replacement property and, in most cases, finalize the transaction within 180 days.
Changes under the TCJA
Some have fretted that tax reform would involve the removal of like-kind exchanges. Fortunately, the TCJA will typically still permit tax-deferred like-kind exchanges of business and investment real estate.
On the flip side, the TCJA will do away with tax-deferred like-kind exchange treatment for exchanges of personal property, from 2018 on out. Despite that ruling, prior-law rules that grant like-kind exchanges of personal property remain in effect if one side of an exchange was concluded by December 31, 2017, but the other side was still open at that time. Know that exchanged personal property must belong to the same category of asset or product.
Like-kind exchanges have complex rules surrounding them, so these arrangements present some risks. For example, if, in a deal, you received cash or other non-like-kind property, or you exchanged the wrong kind of property, you could wind up incurring a substantial tax hit. Please contact us or call 818-334-8623 if you are looking into a like-kind exchange. We can help make certain you’re in compliance with the rules.