If you own appreciated real estate that is held for investment, rental income or used in your business and you are thinking of reinvesting its value into a similar type of property, consider using a Section 1031 like-kind exchange. A successful like-kind exchange will defer federal and state income taxes on the taxable gain until the replacement property is sold.
Individuals, C corporations, S corporations, partnerships, limited liability companies and entities that pay taxes can participate in a like-kind exchange, so long as the real or personal property being exchanged is of the same nature, character and class as the relinquished property:
- Real property is like-kind with all real property, but it is not like-kind with any personal property.
- U.S. real property is not like-kind with non-U.S. real property.
- Personal property is like-kind with personal property, so long as both are in the same asset class for depreciation purposes.
How the exchange works
Like-kind exchanges must be set up as a swap. Most use an independent qualified intermediary (QI) to facilitate the exchange. The QI receives the relinquished property title prior to the close of the “sale” along with the assumption of debts that will be paid on closing. Within 45 days of the property transferring to the QI, you must identify, in writing, up to three replacement properties to be purchased with the sale proceeds (less debts paid). The QI must acquire and deed you at least one identified property within 180 days of the property transfer.
Taxable gain considerations
Although some taxable gain is deferred in a like-kind exchange, you may owe taxes on gains in certain scenarios. Reinvesting less than 100 percent of the relinquished property sale proceeds may trigger taxable gain. For example, if certain income or expenses such as rent or property taxes are paid from the sale proceeds, your taxable gain will be the lesser of the total realized gain from the relinquished property or the shorted reinvestment amount.
If you die with a deferred gain, your deferred gain is eliminated. A gift of property during your life, with a deferred gain, simply transfers the deferred gain to the transferee.
In some cases, an exchange with a related party will cause a like-kind exchange to fail. If your debts assumed by the QI are greater than the debt you assume from the QI, that difference (less any additional equity you pay) creates “boot” and causes taxable gain to the extent such gain is less than the total gain realized upon the property “sale.” Any cash received at the closing of your property is also taxable “boot” to you.
Reverse exchanges, where the QI acquires the replacement property before disposing of the relinquished property, may also trigger taxable gain. Acquiring newly constructed property as replacement property in an exchange is complex. Both have IRS safe harbor procedures and should be discussed and understood prior to undertaking the exchange.
Other scenarios with unique considerations include exchanges or acquisitions involving:
- installment sales
- fractional tenancy in common interest
- multimember partnerships or LLCs where not all partners want to pursue a like-kind exchange
- foreclosures or deed-in-lieu of foreclosures
- partnerships or LLCs that want an exchange to take place over two tax years
- rental vacation homes used for minimal personal purposes
Like-kind exchanges may involve unique IRS considerations and safe harbor procedures, which makes planning essential to maximizing their benefit. An experienced tax advisor can assist in navigating taxable gain issues and making sure your like-kind exchange meets compliance requirements.