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Like-Kind Exchanges of Rental Property Under IRC Code Section 1031

Ines Zemelman, EA
20-Mar-17

Ines Zemelman, EAMar-20-2017

Whenever you sell rental property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain from sale of business or investment property if you buy a similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange is tax-deferred, which means you don’t pay capital gain tax when you dispose of the property and postpone tax payment to the later time. However, the gain is is not tax-free. When you sell the new property acquired as a part of like-kind exchange you will pay tax,

The exchange can involve like-kind property exclusively or it may include cash, liabilities and property that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value. Recognized gain is capital gain on which tax is payable right in the year of transaction and cannot be deferred (postponed)

Who qualifies for the Section 1031 exchange?

Owners of investment and business property may qualify for a Section 1031 deferral. Such owners may be Individuals, C corporations, S corporations, partnerships, limited liability companies, trusts and any other taxpaying entities. Qualifying entities or individuals may set up an exchange of business or investment properties for business or investment properties under Section 1031.

What are the different structures of a Section 1031 Exchange?

To accomplish a Section 1031 exchange, there must be an exchange of properties.  The simplest type of Section 1031 exchange is a simultaneous swap of one property for another.

Can exchange transaction be spread over time?

Deferred exchanges are more complex but allow flexibility.  They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.

What is the difference between selling property and using proceeds to buy another property and Section 1031 exchange?

The case of a taxpayer simply selling one property and using the proceeds to purchase another property is a taxable transaction.  Whereas in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property.  Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations.

I heard the term reverse exchange. What is it and does it qualify for tax deferral?

A reverse exchange is more complex than a deferred exchange.  It involves the acquisition of replacement property through a transaction facilitator who holds the title on the property for no more than 180 days.  During this parking period the taxpayer disposes of its relinquished property to close the exchange.

What property qualifies for a Like-Kind Exchange?

Both the relinquished property you sell and the replacement property you buy must meet certain requirements.

  • Both properties must be held for use in a trade or business or for investment.   Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.
     
  • Both properties must be similar enough to qualify as "like-kind."  Like-kind property is property of the same nature, character or class.  Although it may be of a different qualify. For example, land parcel that is improved with a residential rental house is like-kind to vacant land.  However, improvements that are conveyed without land are not of like kind to land.
One exception for real estate is that property within the United States is not like-kind to property outside of the United States. 

What are the time limits to complete a Section 1031 Deferred Like-Kind Exchange?

While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable.  These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.

The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties.  The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary.  Notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.

The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.

How cash involved in Section 1031 transactions is treated?

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.

To avoid premature receipt of cash or other proceeds that jeopardize like-kind qualification of the entire transaction to use an exchange facilitator to hold those proceeds until the exchange is complete.

Your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator. You cannot act as your own facilitator as well - it must be an independent party.

How do you compute the basis in the new property?

The basis of property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments.  The resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction.

Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange.

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.

How do you report Section 1031 Like-Kind Exchanges to the IRS?

You must report an exchange to the IRS on  Form 8824, Like-Kind Exchanges and  file it with your tax return for the year in which the exchange occurred.

Form 8824 asks for:

  • Descriptions of the properties exchanged
  • Dates that properties were identified and transferred
  • Any relationship between the parties to the exchange
  • Value of the like-kind and other property received
  • Gain or loss on sale of other (non-like-kind) property given up
  • Cash received or paid; liabilities relieved or assumed
  • Adjusted basis of like-kind property given up; realized gain

If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.

Ines Zemelman, EA