by Craig D. Hasenbalg and Michael Castaldo III
Whenever a taxpayer sells business or investment property at a price that is higher than the taxpayer’s basis in the property, capital gain tax must be paid on the difference. However, Section 1031 of the Internal Revenue Code (“IRC”) provides an exception to this rule and allows a taxpayer to postpone paying tax on the gain if the proceeds from the sale are reinvested as part of a qualifying “like-kind exchange.” One common misperception about exchanges, however, is that any gain incurred disappears forever. This is not the case. Instead, IRC Section 1031 allows for the deferral of gain, not its complete elimination.
To accomplish a Section 1031 exchange, there must be an exchange of “like-kind” properties. Section 1031 defines “like-kind” as real estate (and only real estate) that is held for productive use in a trade or business or for investment purposes. Properties are of like-kind if they are of the same nature or character, even if they differ in grade or quality. Therefore, real properties typically qualify as being of like-kind regardless of whether they are improved or unimproved. Farmland and sky-scrappers are “like-kind” properties, just as an apartment complex with many units and a house rented to a single tenant are “like-kind.” Regardless, the rule is the same: any gain from the sale of real estate that is part of a properly structured exchange is deferred if the proceeds of sale are reinvested in other like-kind property. If, as part of the like-kind exchange, the taxpayer also receives other (not like-kind) property or money, gain must be recognized to the extent of the other property or money received. Losses, however, cannot be recognized, making Section 1031 particularly unattractive is the real estate to be sold has a tax basis higher than the price.
The simplest type of Section 1031 exchange is a simultaneous swap of one property for another. Deferred exchanges (where relinquished property is sold before any replacement property can be purchased) are more complex but allow flexibility. To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. Even more complex than a deferred exchange, exists the reverse exchange. A reverse exchange involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange.
Under the Tax Cuts and Jobs Act, Section 1031 now applies only to exchanges of real property and not to exchanges of personal or intangible property. An exchange of real property held primarily for sale still does not qualify as a like-kind exchange. A transition rule in the new law provides that Section 1031 applies to a qualifying exchange of personal or intangible property if the taxpayer disposed of the exchanged property on or before December 31, 2017 or received replacement property on or before that date. Thus, effective January 1, 2018, exchanges of machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property and intangible business assets generally do not qualify for non-recognition of gain or loss as like-kind exchanges. However, certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible for non-recognition of gain or loss as like-kind exchanges.
The Section 1031 tax-deferred exchange can be a useful tool for investors and business owners by creating an alternative way to raise cash when buying certain property. Whether simple or complex, a Section 1031 exchange has extremely strict timelines and deadlines in order to successfully defer the tax on any gain. If you have any questions about or think you may be able to benefit from a successful like-kind exchange, please reach out to the attorneys at Ottosen DiNolfo Hasenbalg & Castaldo Ltd. to learn more.