The real estate market has been tough recently, however, there are still profitable opportunities (with high resulting tax bills) that may be attractive. If you’re planning to sell commercial or investment real estate that has appreciated significantly in value, one way to defer a tax bill on the gain is with a Section 1031 “like-kind” exchange. A Section 1031 like-kind exchange is a provision in the U.S. tax code that allows for the deferral of capital gains tax on the sale of certain appreciated real estate. To do this, two opposing parties would exchange property rather than sell it outright. The term "like-kind" is broadly defined, and most real property is considered like-kind with other real property. However, it's important to note that neither the relinquished property nor the replacement property can be real property held primarily for sale.
The Tax Cuts and Jobs Act (TCJA), signed into law in December 2017, made significant changes to the U.S. tax code, including amendments to Section 1031 like-kind exchanges. One notable change is that tax-deferred Section 1031 treatment is now limited to real property exchanges, and it is no longer allowed for exchanges involving personal property. Real property includes land and buildings, but not personal property. If you’re unsure if the property involved in your exchange is eligible for like-kind treatment, please contact us to discuss the matter.
How Does a Like-Kind Exchange Work?
The property owner (exchanger) must identify potential replacement properties within 45 days of the sale of the relinquished property. The identification is typically done in writing and submitted to a qualified intermediary (QI), who is a neutral third party facilitating the exchange. There are rules and guidelines regarding the identification, such as the three-property rule (identifying up to three properties without regard to their fair market value) or the 200% rule (identifying any number of properties as long as their total fair market value does not exceed 200% of the relinquished property's value).
The exchanger typically uses a qualified intermediary, a third party responsible for holding the funds from the sale of the relinquished property and facilitating the acquisition of the replacement property. The QI facilitates the direct transfer of the deed from the seller of the relinquished property to the buyer and holds the funds until they are used to acquire the replacement property. The exchanger has a total of 180 calendar days from the sale of the relinquished property to complete the acquisition of the replacement property, and the exchange must be completed within this timeframe to qualify for tax deferral.
The funds from the sale of the relinquished property are reinvested into the identified replacement property or properties.
In some cases, the exchanging properties aren’t equal in value, so some cash or other property is added to the deal. The extra cash added is considered a "boot". If boot is involved, you’ll have to recognize your gain, but only up to the amount of boot you receive from the exchange.
Let’s say you exchange business property with a basis of $100,000 for a building valued at $120,000, plus $15,000 in cash. Your realized gain on the exchange is $35,000, and you receive $135,000 in value for an asset with a basis of $100,000. However, since it’s a like-kind exchange, you only have to recognize $15,000 of your gain, which is your "boot" amount.
Note: If the property you’re exchanging is subject to debt from which you’re being relieved, the amount of the debt is also treated as boot.
Like-kind exchanges can be a great tax-deferred way to dispose of investment, trade or business real property. But you have to make sure to meet all the requirements. Contact us if you have questions or would like to discuss the strategy further.