There are many tax-deferral strategies used by successful investors. One of those tax instruments is the code Section 1031 Like-Kind Exchange. Businesses are able to exchange assets used in a trade or business and defer paying taxes on gains from the sale of real property.
Previously, businesses were able were able to exchange personal property such as vehicles machinery, equipment, and furniture used in the trade or business, as long as the personal property was in the same asset class. However, on December 20, 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), a new tax law that went into effect on January 1, 2018, which states that only real property is eligible for the 1031 Like-Kind Exchange.
Under TCJA, Section 1031 will now only apply to exchanges of real property held in a trade or business or for investment. Thus, personal properties have been eliminated.
1031 Exchange Requirements
In order to qualify for the 1031 Exchange on real estate, you must meet the following requirements:
- 45/180 Day Rules
- Have a Qualified Intermediary
Congress established the 45 and 180 day rules to prevent taxpayers from deferring the recognition of gain for an unreasonable time period. Taxpayers have 45 days from the date of sale on the relinquished property to identify potential replacement properties. The properties must be documented and delivered to a qualified intermediary or seller of the replacement property. Once a replacement property is identified, the taxpayer will have 180 days to close on the property.
A qualified intermediary is the person facilitating the exchange to ensure that it proceeds according to plan. Due to strict rules regarding premature receipt of cash or other proceeds, the facilitator will manage the escrow account until the exchange is complete to avoid forfeiting the 1031 Exchange. Additionally, like-kind exchanges for real property outside of the United States will not qualify.
If you have real property that qualifies under Section 1031, what are the different tax treatments between a partial and full implementation of the 1031 Exchange?
Full implementation of the like-kind exchange treatment is when no “boot” is received during the exchange. Boot is when you receive compensation in addition to the property that qualifies for like-kind exchange treatment to compensate for the difference in value of the properties. In most cases, this would be cash and/or a relief of liabilities. Under full implementation with no boot received, the gain is deferred, and the basis of the like-kind property received is the fair market value (FMV) of the new property, minus the deferred gain.
What if there is a loss on the relinquished property under the full implementation of the exchange? In the case of a loss with or without receiving boot, the loss is deferred. The basis of the new property is the FMV plus the deferred loss.
In comparison, a partial exchange is when you receive boot. In this exchange, you recognize a portion of the gain that was realized from the sale of the relinquished property. The gain recognized is the lower of the gain realized or boot received.
Example: An investment firm owns an investment property with an adjusted basis of $850,000 and is worth $1,000,000. The property is exchanged for another property worth $950,000 and the investor receives $50,000 in cash. The realized gain on the relinquished property is $150,000, but the investor recognizes the gain only to the extent of the $50,000 cash received. The remaining $100,000 gain is deferred, and the basis of the new property is $850,000.
The 1031 like-kind exchange provision is an excellent tax instrument to utilize as businesses and investors look to grow their portfolios in a hot real estate market. Business owners looking to take advantage of the 1031 like-kind exchange provision should talk with a tax advisor to ensure that the proper steps are accounted for.
For questions about this or any other tax matters, please contact our tax advisors at 301.231.6200.