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, which is why 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 will receive 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 is serving the same purpose as the replaced property. For instance, virtually any type of realty can be exchanged for any other type of 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:
- classified as such under state and local laws, with a few exceptions, such as intangible assets like stocks, bonds, other securities, debt instruments, and partnership interests, or
- specifically listed in the regulations, or
- where the facts and circumstances would make such a classification reasonable.
This classification applies to each distinct asset, where distinct means that it was acquired separately from other assets or that it can easily be separated from other assets. Some structural components, such as machinery or other equipment, could be considered real property if it is part of the permanent structure or if it serves a function for using or occupying the building, but does 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 new tax package passed by the Republicans at the end of 2017, known as 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, although a transition rule will allow 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 the fair market value of the personal property does not exceed 15% of the replacement real property, which includes 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:
- personal property that is not an investment or used in business
- foreign real estate, because capital gain taxes may not be collected on the ultimate disposition of the property
- property held for resale, such as inventory
- partnership interests, securities, notes, or other financial instruments
- depreciable tangible property, such as office equipment
- intangible nondepreciable personal property, such as copyrights, patents, and trademarks
- nondepreciable personal property, such as antiques, art, and coin and stamp collections
If an exchange occurs between related parties, then 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 off within the 2-year period, then the tax that would have been incurred because of the exchange will be assessed in the year that the property is disposed of, unless it was because:
- of the death of one of the parties
- of an involuntary conversion
- the parties knew that there would be a conversion, or
- the exchange was not to avoid tax, which either party must prove.
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), then the new property acquires the same basis as the traded property, where 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, and if there is a recognized gain or loss, then investment property must be reported on Schedule D, Capital Gains and Losses and 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 FMV of the boot. So if the property seller receives a car plus 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
- You exchange real estate used in business that has a FMV of $25,000 and a basis of $20,000 for rental real estate that has a market value of $16,000 and $9000 in cash.
- Therefore, you recognize a gain of $25,000 − $20,000 = $5000.
- The basis of the replacement property is $20,000 − $9000 received + $5000 recognized gain = $16,000.
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 that were also used for vacation purposes by the owners or the owner's family. To qualify for the safe harbor:
- the residences had to be owned at least 24 months before the exchange and during each of the 2 years, the residences were rented at fair market rents for at least 14 days
- the replacement residence is owned at least 24 months after the exchange and rented at market rents for at least 14 days during each of the 2 years, and
- the personal use by the owner or his relatives does not exceed the greater of 14 days or 10% of the days the residence was rented at FMV during the year. Revenue Procedure 2008-16
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
- Adjusted basis of relinquished property: $10,000
- Additional cash paid for replacement property: $15,000
- Adjusted basis of replacement property: $25,000
When boot is received, then there may be recognized gain, = to the lesser of the
- realized gain, = to the amount realized − the adjusted basis, or
- the FMV of the boot received.
However, the boot is not recognized if there is a realized loss.
Example: Calculating Taxable Gain and Adjusted Basis for Property Exchanges Involving Boot
- You have property with an adjusted basis of $20,000 and a FMV of $24,000.
- You exchange it for property with a FMV of $19,000 + $5000 cash.
- Your recognized gain is the lesser of $24,000 of the amount realized − $20,000 adjusted basis = $4000 or the FMV of the boot, $5000.
- Therefore, your taxable gain is $4,000.
- The adjusted basis of your new property is the same as the old, $20,000.
If there is debt associated with the property, then the exchanged debt is netted out, so the party receiving the smaller debt will have been 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 are considered to have 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, then 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:
- a qualifying security or guarantee arrangement
- qualified escrow accounts or trusts
- a qualified intermediary, or
- the payment of interest or a growth factor.
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.
There are 2 types of exchanges that are finalized over time. A deferred exchange is one in which the taxpayer first transfers investment or business property to another and then later receives a like-kind property. 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 what is called 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 exchange will not be considered like-kind unless the following requirements are met:
- The property to be received must be identified within the identification period, which begins when the relinquished property is transferred and ends by the 45th day thereafter. The replacement property must be identified by a written document or agreement with the other person, who is not related to the taxpayer, involved in the exchange within the 45 day identification period.
- The exchange must be completed within the exchange period: the property must be received by the earlier of
- the due date of the taxpayer's return, including extensions in the year the transfer is made, or
- within 180 days after the date the relinquished property is transferred.
- For exchanges of more than one property, the time limits are determined by the earliest date in which any property is transferred.
Note that the durations of the identification period and the exchange period are absolutes: they are not extended if they end on a holiday or a weekend.
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 intermediary. The QI cannot be related to the taxpayer nor be a business or trust that is 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 have 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 be in compliance 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 is following tax rules.
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 ownership of the property 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 the transfer of 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 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.
- Intangible personal property or non-depreciable tangible property may qualify for like kind treatment only if the properties are similar. So, for instance, a copyright for a song can be exchanged for the copyright of a different song, but not for a copyright for a novel. Trademarks, trade names, and other intangibles that can be priced individually can also qualify for like kind treatment.
General Asset and Product Classes
There are 2 other types of properties that qualify 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 consists of 13 groups of depreciable tangible business property including:
- office furniture, fixtures, and equipment
- information systems
- computers and peripheral equipment
- data handling equipment, except computers
- automobiles and taxis
- light and heavy trucks
General Asset Classes are the general classes stipulated by the IRS that are used to determine depreciation periods. However, if the exchanged properties are in different General Asset Classes, then they do not qualify for the tax-free exchange even if they happen to be in the same Product Classes.
Product Classes are grouped according to a system developed by the North American Industry Classification System (NAICS) for depreciable tangible personal property. Product classes are defined by the 6 digit product codes of the NAICS. Products with the same product codes can be exchanged tax-free. The classification of the exchanged properties is determined at the time of the exchange.
The like-class tests do not apply to intangible personal property, such as patents or copyrights, or to goodwill. The IRS deems any exchange of goodwill to be a taxable event.
Although the tax-free exchange rules generally apply to the exchange of single properties, multiple properties can also be exchanged in like groups by placing the assets into their respective classes.