Reading about proposed changes to like-kind exchange rules under Internal Revenue Code Section 1031 is a bit like watching the popular television sitcom Friends. Will Ross and Rachel end up together? Will they not? Were they on a break? Every year, like-kind exchanges are in the news and on the proverbial chopping block of tax breaks perceived to be designed to benefit the rich at the expense of the middle class. It is important to step back and understand what a like-kind exchange is and, more importantly, what it is not, along with some of the rules that are critical for investors contemplating such transactions.
What is a Like-Kind Exchange?
So, what is a like-kind exchange commonly referred to as a 1031 (deriving its name from the relevant Code Section)? To answer this question, we need to first understand a basic rule of US income tax principles. Internal Revenue Code Section 61 provides for taxation of gross income from all sources derived unless specifically excepted by the code. Congress often exercises what is commonly referred to as legislative grace to provide for exclusions of income or the allowance of deductions. Congress did exercise legislative grace by enacting Section 1031.
Now that we are all on the same page that you will be taxed on all items of gross income, let’s look at the exceptions, specifically Code Section 1031.
- In general, no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.
What does this mean? First let’s look at the word “recognized.” There are two concepts to understand here.
- First, did you REALIZE a gain on a transaction? Simply put it, did you sell or exchange the property for an amount exceeding its adjusted tax basis (what you originally paid for the property, subsequent improvements, depreciation etc.). If the answer is Yes, we now move to the second concept.
- Do you have to RECOGNIZE the gain? General principles would say you do, in which case you report the gain on the appropriate sections of the tax return, calculate the tax owed and do your civic and patriotic duty by sending a check to the government.
This is where the 1031 rules come into play. As noted above, no gain (or loss) shall be RECOGNIZED. So, did you realize a gain? Yes. Do you need to recognize the gain? No.
So, the question is: can there be a gain and I don’t have to pay tax on it? Short answer: No.
Section 1031 provides for a deferral of the recognition of the gain, not the realization. Put it simply, you don’t have to pay tax now, but you will later. Well, maybe…
It is critical to understand that Section 1031 does not provide for the gain to never be taxable, you are simply allowed to reinvest the gain into another project and defer paying the tax on this gain until the new property is sold. Unless of course, you do another 1031. This is complicated and it only gets harder.
How to Leverage a 1031
Now that we are hopefully on the same page of what Section 1031 is designed to accomplish is where the real fun begins. How do you actually do it?
Using a trusted accountant with 1031 experience is a must. The rules and requirements are extremely onerous and there is NO flexibility with those rules. You have to structure and effectuate the transaction in a very specific, prescribed manner or you will not meet the strict definition of Section 1031 and accordingly, the deferral will not be respected. So, you will pay tax, your investors will be mad, your accountant will be sad, and you will likely go back to looking at whether Section 61 and imposition of tax does in fact have constitutional authority.
Like-Kind Limitations
Prior to enactment of the 2017 Tax Cuts and Jobs Act (TCJA), like-kind exchanges were available for most assets that were used in a trade or business or held for investment. After TCJA, like-kind exchanges are only available for real estate property used in a trade or business or held for investment.
So, TCJA narrowed the scope to real estate. But what kind of real estate? The real estate must be used in a trade or business (think developers, landlords) or for investment. Basically, don’t try to sell the personal condo you bought in 2018 for $140,000 for $950,000 because that is what someone is willing to pay. The gain on such transaction, even if you use all the proceeds to buy a new house for $1,200,000, will be recognized (subject to principal residence rules, etc.). Now if you bought the same property for investment purposes and rented it out, the property could meet the “held for investment” rules and you could defer recognition of the gain if you exchanged it for another investment property.
While a like-kind exchange is solely a deferral mechanism, there are real life cash tax savings due to time value of money and rate arbitrage that are important to consider and compute. Our experts can help you understand the specific rules and steps to perform a like-kind exchange with examples used to illustrate the tax savings.
Please join us in the upcoming Concrete Advice Newsletter as we continue the discussion about like-kind exchanges including specific steps and criteria required to complete a successful exchange. And if you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
