The highly publicized tax proposals recently issued by the GOP Senate and House of Representatives would impose restrictions on Code Section 1031 “Like-Kind Exchange” transactions, one of the most beneficial tax provisions currently available to taxpayers in the real estate and construction industry. Under the proposed tax plans, many transactions that currently qualify for 1031 status will be prohibited for 2018 and beyond. As a result, contractors and real estate developers currently considering exchanging business property or equipment should act now. Successful execution of 1031 transactions in the current year will yield two significant tax benefits:
- Current year deferral of taxable gain from 1031 exchanges
- Lower tax rates to be applied to future taxable gain per anticipated tax legislation
Below are the basic concepts associated with the like-kind exchange provision and how your company can secure these major tax savings opportunities before they are no longer available.
What is a Like-Kind Exchange?
The 1031 like-kind exchange provision provides taxpayers with the ability to temporarily defer any recognition of taxable gain resulting from the exchange of like-kind property either used in a trade or business, or held for investment purposes. According to the IRS, the idea behind this provision is that businesses should not be subject to tax liability when qualified property is merely exchanged for similar property, and not sold for profit.
Like-kind property is generally defined as two or more properties that share the same functional characteristics, regardless of age, luxury, class, or brand of equipment. For example, the exchange of a 1999 Toyota pick-up truck for a 2017 Mercedes-Benz pick-up truck could potentially qualify as a 1031 transaction since both vehicles share the same functionality (cargo transportation). Under Code Section 1031, real property is generally considered like-kind with other real property.
Per current tax law, the like-kind exchange provision is not applicable for the following types of transactions:
- Sale of investment securities, such as stocks and bonds
- Sale of inventory
- Sale of ownership interest in a partnership
- Sale of personal property
Calculating Realized and Deferred Gain
The effects of a 1031 transaction can result in a partial or total deferral of realized gain depending on whether “boot” has been received as a result of the exchange.
- Realized vs. Recognized – It is important to understand the difference between realized gain and recognized gain. While realized gain reflects the positive change in the taxpayer’s financial position as a result of the transaction, such gain derived from a 1031 transaction may or may not be taxable in the same tax year when the transaction occurred. Recognized gain is the portion of realized gain that is subject to taxation in any given tax year.
- Boot – In general, boot is defined as money or other property received that is not of like-kind, such as cash or relief of indebtedness. For transactions where a taxpayer receives both boot and like-kind property in exchange for the relinquished property, the portion of realized gain to be recognized and subject to taxation in the year of the transaction is limited to the amount of boot received.
Requirements for 1031 Transactions
In an effort to deter taxpayers from abusing the 1031 provision by using the code solely to avoid paying federal taxes, over the past several years Congress has developed several parameters. Listed below are some of the more important rules taxpayers must follow in order to successfully execute a qualified 1031 transaction.
- Replacement Property Rules – When identifying replacement property under 1031 transactions, taxpayers have a choice to follow one of two general rules: the “Three Property Rule” and the “200% Rule”. The three property rule states that taxpayers may choose up to three replacement properties without regard to their fair market values. Under the 200% rule, taxpayers may select an unlimited number of properties if the aggregate value of the properties does not exceed 200% of the relinquished property on the date of sale.
As is the case with many tax code provisions, there is an exception to the general rules relating to replacement property. If the taxpayer selects properties whose amounts or fair market values are in excess of the Three Property or the 200% rules, then the taxpayer must acquire at least 95% of the aggregate fair market value of all identified properties to qualify for 1031 treatment.
- 45/180 Day Rules – The like-kind exchange provision is appealing to many because the physical exchange of relinquished property for replacement property does not have to be simultaneous. These deferred exchanges are commonly referred to as Starker exchanges. To prevent taxpayers from potentially delaying the recognition of taxable gain for an unreasonable period of time, Congress established the 45 and 180 day rules with the Deficit Reduction Act of 1984. The rules require taxpayers to identify replacement property within 45 days of the transaction date; the taxpayer must provide written notification to a qualified intermediary to identify and describe potential replacement property. The physical exchange of the relinquished property and the replacement property must be completed within 180 days of the transaction.
- Qualified Intermediary – The tax code prohibits taxpayers from directly receiving or handling any cash or other non like-kind property resulting from the exchange of relinquished property. Therefore, a qualified intermediary must be employed to facilitate the transaction and administer the consideration/property received.
Any related parties who have had a financial relationship with the taxpayer during the two years preceding the like-kind exchange transaction are disqualified from being considered as a qualified intermediary (ex: financial advisor, insurance agent, etc.).
Reverse Deferred 1031 Exchange
In some instances, taxpayers may structure their 1031 transaction differently by purchasing replacement property before relinquishing their business property. These 1031 transactions are known as reverse deferred 1031 exchanges, or reverse Starker exchange. Reverse Starker exchanges share the same principals and are subject to the same rules as the traditional deferred exchanges. They are particularly common in the real estate industry, where developers may find it necessary to move quickly to acquire the desired replacement property before they have decided on which property they will forfeit as consideration.
Proposed Tax Legislation: Limitations on Qualifying 1031 Property
At the time of this publication, the recently proposed tax plans put forth by the House Ways and Means Committee and the Senate Committee on Finance would impose restrictions on qualifying 1031 transactions by limiting its application to real estate property. The proposals from the two chambers of Congress are subject to reconciliation to settle timing differences between the two plans: under the Ways and Means proposed legislation, taxpayers must fulfill all 1031 transaction requirements in accordance with current law by 2017 year end to qualify for tax deferral treatment. The Senate’s proposition is more forgiving for taxpayers looking to enter into last minute 1031 transactions, permitting tax-deferral status if either the replacement property is received by 2017 year end, or the relinquished property transferred by 2017 year end.
If passed, the tax benefits under like-kind exchanges will be severely limited for future tax years. Real estate and construction contracting firms must initiate 1031 transactions before the current year end to guarantee maximum tax savings. Like-kind exchanges are among the most complex transactions to execute due to the many compliance requirements involved. For more information on 1031 exchanges, or if your company is considering entering into a like-kind exchange transaction, please contact Aronson’s Construction and Real Estate Group at 301.231.6200.