Passing the 2017 tax reform law required a delicate budget-balancing act. Congress sought to minimize the long-term impact that the law commonly known as the Tax Cuts and Jobs Act (TCJA) would have on the federal deficit. As changes were made to reduce taxes in some areas, such as the new corporate tax rate, others were made to offset the total cost of the law. Like-kind exchanges under Section 1031 fell into the latter category. If you used like-kind exchanges in the past, it will be important to note how the rules have changed since the TCJA went into law.
Like-Kind Exchange Recap
Section 1031 exchanges are open to both individuals and businesses with real estate held for investment, rental income or business purposes. Taxpayers could use the like-kind exchange rules to defer state and federal income tax if they “swapped” appreciated real or personal property for a similar type of property. The state and federal income tax deferral on the taxable gain of the initial property sale remained in place until the replacement property was sold. For that reason, many commercial real estate companies found the like-kind exchange to be a useful tax-minimization tool.
The TCJA made changes to limit the use of the program, and while it may not have a significant impact on commercial real estate companies, taxpayers looking to use a like-kind exchange will want to pay attention to how the definition of like-kind has been changed.
As under the previous rules, like-kind property in the TCJA generally means that the property being exchanged is of the same nature, character and class as the relinquished property. So, for example, you could not sell a business property and invest the gain from that sale into a vacation home. Like-kind property in the pre-TCJA rules included the following provisions:
- Real property is like-kind with all real 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.
The TCJA removes personal property from the least of property eligible for like-kind exchanges under Section 1031. After Dec. 31, 2017, like-kind exchanges are limited to real property held for productive use in a trade or business or for investment, in other words, not held for personal use or primarily for sale or exchange.
Other than the new limitations on the type of property eligible, like-kind exchanges will continue to function as they did prior to the TCJA. Deferred like-kind exchanges must be set up as a swap, and they must involve an independent, qualified intermediary (QI). The seller transfers the title of the relinquished real property and the assumption of debts to be paid as part of closing to the QI prior to the sale of the relinquished property. Additionally, the seller identifies, in writing, up to three replacement properties for the QI to purchase within 45 days of transferring the relinquished property to the QI. The QI must acquire and deed the seller at least one identified property within 180 days of the property transfer to the QI.
Taxable Gain Considerations
Although some taxable gain is deferred in a like-kind exchange, commercial real estate companies may owe taxes on gains in certain scenarios. Reinvesting less than 100 percent of the relinquished property sale proceeds may trigger taxable gain. If the seller dies with a deferred gain, no tax is due to the extent of the property’s value the estate reports as of the date of death. A gift of property during life, with a deferred gain, simply transfers the deferred gain to the transferee.
Complex rules determine the taxable gain of some like-kind exchanges. In some cases, an exchange with a related party will cause a like-kind exchange to fail. If debts assumed by the QI are greater than the debt the seller assumes from the QI, that difference less any cash paid creates “boot” and causes taxable gain to the extent such gain is less than the total gain realized upon the “sale” of the relinquished property. Any cash received at the closing of the replacement property is also taxable “boot” to the seller.
In other cases, the QI might wind up acquiring the replacement property before he or she disposes of the relinquished property. This is what is known as a Reverse Exchange. Commercial real estate companies may also wish to acquire newly constructed property as replacement property in an exchange. Both of these exchanges are complex to do under the IRS’s safe harbor procedures and should be discussed and understood prior to undertaking the exchange.
A real estate purchaser may want to conduct a cost segregation study, especially with the new enhanced depreciation benefits available under the TCJA. In that case the purchaser should be aware that any subsequent like-kind exchange of the real property will not include amounts reclassified as personal property and depreciated accordingly because the new law only allows real property to qualify.
Commercial real estate companies may use an installment sale as part of an exchange, but there are special rules that apply and need to be reviewed and understood.
Like-kind exchanges could be used to exchange or acquire a fractional tenancy in common interest, but taxpayers should consult the IRS’s safe harbor procedures that apply.
Finally, exchanges involving a multimember partnership or LLC when some partners or members want to cash out and others want to exchange are very risky to structure and difficult to accomplish successfully; these should be thoroughly planned and executed.
It may be possible to plan for a like-kind exchange involving a foreclosure or a deed-in-lieu of foreclosure. It may also be possible to plan for a like-kind exchange by a partnership or LLC over two tax years.
For more information about this and other tax and accounting issues, call or email Bennett Berg at 312.602.6820 or contact your local CBIZ MHM professional.