Tax-Free Like-Kind Exchanges Of Property (§1031 Exchanges)

Like-kind property used in a trade or business or for investment purposes can be exchanged for similar property used for the same purpose without incurring taxes in the year of the exchange. Instead, the replaced property receives the carryover basis of the exchanged property. Like-kind property is defined in IRC §1031, so such exchanges are often called §1031 exchanges. The relinquished property is the property given, while the replacement property is the property received. Because capital gains taxes may have to be paid on the ultimate disposition of the replacement property, §1031 exchanges are also called tax-deferred exchanges, even though the exchange itself is tax-free. Furthermore, taxes may not ever have to be paid on the property if the owner dies while still owning it since the property receives a stepped-up basis at death, or any gains may be offset by losses on the disposition of other property.

The term like-kind refers to the nature of the property and not to its quality in that it serves the same purpose as the replaced property. For instance, virtually any realty can be exchanged for any other realty tax-free unless the realty is located in a foreign country. So, farms can be exchanged for apartments, raw land can be exchanged for office buildings, and residences can be traded for warehouses.

Only real property can be used in tax-free exchanges. Real property is defined as any property:

This classification applies to each distinct asset, distinct meaning it was acquired separately from other assets or it can easily be separated from other assets. Some structural components, such as machinery or other equipment, could be considered real property if they are part of the permanent structure or serve a function for using or occupying the building but do not contribute to income. For instance, a backup generator for computer equipment may be considered real property if it is a permanent part of the property and it does not contribute to income since it is only used to continue production under a power failure. Other factors to consider to determine whether property is real property is whether the component was designed to be portable or whether it was constructed during the construction of the building.

Under the Tax Cuts and Jobs Act, Section 1031 will apply only to real property exchanges but will no longer cover exchanges of personal or intangible property. However, a transition rule allowed like-kind exchanges for personal or intangible property if the exchanged property was disposed of or replacement property was received by 2018. There is a personal property safe harbor for exchanges involving real estate and some personal property, where the personal property will be considered incidental if its fair market value does not exceed 15% of the replacement real property, including the value of all replacement real property, not just the real estate containing the personal property.
Source: Like-Kind Exchanges - Real Estate Tax Tips | Internal Revenue Service

Properties that cannot be exchanged tax-free include:

If an exchange occurs between related parties, both parties must retain the property for at least 2 years after the transaction to be treated as a nontaxable like-kind exchange. If the property is disposed of within 2 years, then the tax that would have been incurred because of the exchange will be assessed in the year the property is disposed of, unless it was because:

In a tax-free exchange, the replacement property receives the carryover basis of the relinquished property. If the like-kind exchange involves properties depreciated under the Modified Accelerated Cost Recovery System (MACRS), the new property acquires the same basis as the traded property, and the same depreciation rate and method must be continued for the traded property. Any additional cash paid is depreciable as new MACRS property with a new recovery period. If the exchanged property is subject to depreciation recapture, then the recaptured amount is fully taxable as ordinary income.

Although there is no holding period requirement for the relinquished property, the IRS has ruled that when the property was held only for a short time, before any income was earned or before any realized appreciation of the relinquished property, then it was not held either as an investment or for business, so the property will not qualify for the §1031 exchange.

Exchanges of like-kind property must be reported on Form 8824, Like-Kind Exchanges. A recognized gain or loss on investment property must be reported on Schedule D, Capital Gains and Losses. A gain or loss on business property must be reported on Form 4797, Sales of Business Property.

If the property is held till death, then the unrecognized gains are never subject to income tax since the property receives a stepped-up basis equal to the fair market value (FMV) on the date of death. If an exchange involves boot, such as cash or other property, to equalize the exchange, then that boot is taxable income, but the boot increases the adjusted basis of the replacement property by the boot's FMV. So if the property seller receives a car + cash as boot, then both the car and the cash will be taxable income. The FMV of the car is taxable income because it is not a like-kind property exchange. Exchanges between related parties may be tax-free, but both parties must retain the exchanged property for at least 2 years afterwards.

Example: Calculating Gain and Basis for an Exchange Like-Kind Property

Losses are generally not deductible. However, the loss of any unlike property used for business or investment purposes exchanged in addition to like-kind property can be claimed, with the loss = its adjusted basis − its FMV.

Personal Safe Harbor for Rental Residences

Personal property cannot be exchanged for investment property tax-free, so problems may arise if a property is used both for personal and investment purposes, such as using and renting out a vacation home. There is a safe harbor for the exchange of rental residences used for vacation purposes by the owners or the owner's family. To qualify for the safe harbor:

So if you rented out a vacation home for 200 days out of the year, then use by either you or your family must not exceed 20 days in that same year.

Boot: Additional Cash or Property for a Like-Kind Exchange

Because property exchanges are rarely equal in value, they are often accompanied by additional cash or unlike property to equalize the FMV of the exchanged assets, called boot. When boot is paid, the FMV of the boot is added to the adjusted basis of the replacement property.

Example: Calculating the Adjusted Basis the Replacement Property

When boot is received, then there may be recognized gain, = to the lesser of the

However, the boot is not recognized if there is a realized loss.

Example: Calculating Taxable Gain and Adjusted Basis for Property Exchanges Involving Boot

If there is debt associated with the property, then the exchanged debt is netted out. The party receiving the smaller debt is considered to have received boot to the extent that the received debt liability is less than the transferred debt liability. So, if you exchange property that has a $125,000 mortgage for property that has only a $50,000 mortgage, then you received boot of $75,000. The party receiving the larger debt is not considered to have received boot.

Boot is reported on Form 8824, Like-Kind Exchanges, which must be filed in the exchange year. If the exchange is between related parties, the form must also be filed in the 2 succeeding years to ensure that both parties retain the property for at least 2 years.

Because tax-free treatment may not apply to transactions where the taxpayer receives cash, the tax code provides several safe harbors for several types of transactions involving cash. The taxpayer will not have been considered receiving money or property if the transaction involves:

Deferred Exchanges

In seeking a nontaxable exchange property, the taxpayer may find it difficult to find suitable property for an exchange. Tax law permits deferred exchanges subject to strict time limits.

Deferred exchanges are finalized over time.

  1. A deferred exchange is one in which the taxpayer first transfers investment or business property to another, then later receives a like-kind property.
  2. A reverse exchange is one where the replacement property is acquired before the relinquished property is transferred. Reverse exchanges do not qualify for like-kind exchange rules unless they are accomplished through a Qualified Exchange Accommodation Arrangement (QEAA), often simply called an accommodator.

If boot or unlike property is received as part of the deferred exchange, then it will be treated as a sale rather than a nontaxable exchange.

An deferred exchange is not considered like-kind unless these requirements are met:

Note that the durations of the identification period and the exchange period are absolutes: the time is not extended by holidays or weekends.

However, a deferred exchange only qualifies as a nontaxable exchange if the buyer receives no security or right to payment before receiving the property. There are certain exceptions, however, to the security arrangement. The transferor may receive a mortgage, deed of trust, or other type of security interest in the property, or even a third-party guaranty, such as a standby letter of credit. The transferee may also fund a qualified escrow account or trust to guarantee performance.

A qualified intermediary (QI) can also be used to effect a deferred exchange through an agreement with the taxpayer to act as an intermediary. The QI cannot be related to the taxpayer nor be a business or trust controlled by the taxpayer or family members.

Avoid Accommodators Who Commingle Customer Funds

Accommodators are not heavily regulated like financial institutions, even though they handle funds from the public. Some accommodators commingle the funds received from customers to invest the money. Consequently, if an accommodator becomes bankrupt, as a few had when the markets turned south, such as in 2008, the taxpayer may lose some or all the money. Another potential problem is that some accommodators may not comply with tax rules, which could invalidate the §1031 exchange. Hence, it would behoove the taxpayer to ensure that the funds are held in segregated FDIC-insured bank accounts and that the accommodator follows tax rules.

Reverse Exchanges

A reverse exchange, sometimes called a reverse-Starker exchange, is so-called because the replacement property is acquired before the relinquished property is transferred. For reverse exchanges, qualified exchange accommodation arrangements can be used to effect reverse exchanges in which property ownership is transferred to a QEAA until the exchange is completed. The exchange accommodation titleholder (EAT), who cannot be the taxpayer or other disqualified person, is treated as the beneficial owner of the property for tax purposes. The EAT must own the property from acquisition until it is transferred within the 180-day period. The EAT cannot be related to the taxpayer in any way and must be subject to federal income tax.

The EAT's ownership interest must be evidenced by a qualified indicator of ownership, such as a legal title to the property, or other indicators of ownership under commercial law, such as a contract for the deed of the relinquished property.

The relinquished property must be identified within 45 days after transferring the replacement property to the EAT. The replacement property must be transferred to the taxpayer within the earlier of 180 days after the initial transfer of the relinquished property or the due date of the transferor's tax return, including extensions, and that property must be transferred from the EAT to another party within the same period.

However, Rev. Proc. 2000-37 provides a safe harbor for parking transactions. A parking transaction occurs when the taxpayer parks the replacement party with an EAT until the taxpayer can transfer the relinquished property, after which the relinquished property is transferred to an ultimate transferee, and the replacement property is transferred to the taxpayer. Or the EAT may acquire the replacement property first, then immediately exchange it with the taxpayer for the relinquished property. The EAT holds the replacement property until the taxpayer finds a transferee willing to accept the relinquished property.

To qualify for the safe harbor, the property must be held by a QEAA but not longer than 180 days for all properties. The safe harbor does not apply to parking transactions where the replacement property was previously owned by the taxpayer within 180 days of its transference to the EAT. If the rules for the safe harbor are satisfied, then the IRS will not challenge the designation of the properties as replacement or relinquished properties nor will it challenge the EAT as the beneficial owner of the property.

Historical Notes

Before 2018

General Asset and Product Classes

Before 2018, 2 other types of properties qualified for tax-free treatment besides the like-kind classification and that includes exchanges of property that are within either General Asset Classes or Product Classes. General Asset Classes consisted of 13 groups of depreciable tangible business property including:

General Asset Classes were the general classes stipulated by the IRS used to determine depreciation periods. However, if the exchanged properties were in different General Asset Classes, then they did not qualify for the tax-free exchange even if they happened to be in the same Product Classes.

Product Classes were grouped according to a system developed by the North American Industry Classification System (NAICS) for depreciable tangible personal property. Product classes were defined by the 6-digit product codes of the NAICS. Products with the same product codes could be exchanged tax-free. The classification of the exchanged properties was determined at the time of the exchange.

The like-class tests did not apply to intangible personal property, such as patents or copyrights, or to goodwill. The IRS deemed exchanges of goodwill to be taxable events.

Although the tax-free exchange rules generally applied to the exchange of single properties, multiple properties could also be exchanged in like groups by placing the assets into their respective classes.