Section 1031 Like Kind Exchanges are named for Section 1031 of the Internal Revenue Code. Section 1031 states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” Prior to the Tax Cuts and Jobs Act signed by President Trump on December 22, 2017, any property held for productive use in a trade or business could be eligible for tax deferral if it was exchanged for like kind property. The Tax Cuts and Jobs Act revised Section 1031 by inserting the phrase “real property” instead of property. This means that personal property is no longer eligible for a like kind exchange to defer the tax on the gain of the sale of personal property. As a result business equipment and machinery such as tractors and farm equipment are no longer eligible for like kind exchanges and any gain on the sale of such property will be subject to income tax.
Real property continues to be eligible for like kind exchanges. The deferral on the gain of a sale of real property remains an effective way to defer the payment of taxes and keep more capital for investment purposes. With respect to real property, exchanges can be completed upon the sale and purchase of virtually any kind of real property. For example, improved real estate and unimproved real estate generally are considered to be property of a “like kind” for purposes of 1031 non-recognition of gain. As an illustration, land and a building purchased ten years ago for $2 million could be sold for $4 million and the $2 million gain deferred if the $4 million is reinvested in other real property on a timely basis. The basis in the new property would be the $2 million basis in the old property. If the acquired property is later sold for $6 million, the gain would be $4 million at that time.
While properties can be exchanged on a simultaneous basis in order to qualify for a 1031 deferral, as a practical matter it can be difficult to buy and sell property at the same time. Therefore, Section 1031 allows property received in the exchange to be purchased for up to 180 days after the date on which the seller relinquishes the sold property. Additionally, the property purchased must be identified within forty-five days after the date on which the taxpayer sells the property relinquished in the exchange.
If property is sold and an exchange is contemplated to be completed in the future, the seller cannot have legal control of the sale proceeds. Instead, an exchange intermediary should be used to hold the sale proceeds until the new property is acquired. The agreement selling the property should provide that the seller is permitted to assign their rights in the purchase agreement, and the buyer will cooperate with the seller’s efforts to complete a 1031 exchange. Prior to the time of closing on the sale of the property, the seller’s rights in the proceeds are assigned to the qualified intermediary, and the sale proceeds are provided to the qualified intermediary until needed to purchase the acquired property. The agreement between the seller and the qualified intermediary should provide that if the seller does not complete a 1031 exchange, the sale proceeds will then be released to the seller. Use caution when selecting an intermediary and make sure they hold your funds in a separate account. Qualified intermediaries are not regulated.
It is important to remember that the 1031 exchange is applicable to a “taxpayer”. What this generally means is that the entity or individual selling the property must also be the same entity or purchaser buying the exchanged property. The properties do not need to be of the same value. For example, if a property acquired for $2 million is sold for $4 million and a $6 million property is purchased, the basis in the new property will be $4 million ($2 million basis in the original property and the additional $2 million needed to purchase the acquired property). If the acquired property has a purchase price less than the sold property the “boot” which is the excess will be taxable income.
In order to take advantage of the largest possible deferral, the purchased property should be equal or greater in value than the sold property. If the purchased property is financed, the proceeds of any financing which are in excess of that needed to acquire the replacement property will also be deemed to be boot and be taxable. Therefore, financing should be limited to the amount of money necessary to close on the replacement property in addition to the proceeds of the sold property.
Section 1031 exchanges will continue to be an effective method of deferring taxation of the gains of the sale of real property even with the reduced taxation rates after the Tax Cuts and Jobs Act. Care must be taken to prepare for and effectuate the exchange prior to the sale of the property and in connection with the acquisition of the replacement property. Consultation and planning with your legal, tax, and real estate advisors can ensure compliance with the requirements of Section 1031.
This information is general in nature and should not be construed as tax or legal advice.