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Like-Kind Exchanges

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1031 EXCHANGES: 2018 UPDATES & IMPACTS

JULY 1, 2018
MELINDA D. KORCZYNSKI, CPA

2017 signaled the end of the era of 1031 exchanges of personal property but preserved real property exchanges as a result of the Tax Cut and Jobs Act which was signed into law on December 22, 2017 and became effective January 1, 2018.

1031 Exchanges: The Basics

A 1031 exchange is a very important tax planning arrangement involving the selling and buying of similar real property assets. This planning arrangement is commonly called a “like-kind exchange.” Like-kind exchanges generally allow owners to postpone the recognition of gain on the disposition of real property held for business or investment. The tax savings realized from participating in a like-kind exchange can be substantial.

A like-kind exchange provides a wonderful alternative to selling property outright. The sale of property may cause you to recognize and pay taxes on any gain on the sale. A like-kind exchange, on the other hand, allows you to avoid gain recognition through the exchange of qualifying like-kind properties. The gain on the exchange of like-kind property is effectively deferred until you sell or otherwise dispose of the property you receive in the exchange.

The IRS allows this tax-deferred transaction because it recognizes that you shouldn’t be taxed on a gain when your economic position remains the same (because you have merely exchanged one property for another). You will, however, have to recognize gain on any cash or unlike property that you receive in the exchange.

Only qualifying property may receive like-kind treatment. To qualify, both the real property you give up and the real property you receive must be held by you for investment or for productive use in your trade or business. Buildings, rental houses, and land are examples of property that may qualify. Like-kind exchanges provide a valuable tax planning opportunity if:

  • You wish to avoid recognizing taxable gain on the sale of property that you will replace with like-kind property;
  • You wish to diversify your real estate portfolio without tax consequence by acquiring different types of properties with the exchange proceeds;
  • You wish to participate in a very useful estate planning technique which allows continued deferral of tax consequences and a step up in tax basis at death that would be tax free for decedents with estates valued at less than $11,180,000; or
  • You would likely generate an alternative minimum tax liability upon recognition of a large capital gain in a situation where the gain would not otherwise be taxed. (The like-kind exchange shelters otherwise taxable gain from the alternative minimum tax.)

{1031 HIGHLIGHTS}

  • Tax Code has allowed 1031 exchanges since The United States Revenue Act of 1921
  • Allowed for qualified real estate related exchanges – no longer allowed for personal property after 2017
  • Transition rules allow a personal property exchange to be completed in 2018 under certain conditions
  • Foreign real estate does not qualify as like-kind property in the U.S.
  • 45 day identification and 180 day exchange periods remain unchanged as does the role of the Qualified Intermediary for delayed exchanges
  • 180 days, or the tax filing deadline, including extensions, for the year of the sale is the maximum allowed to acquire replacement property in a delayed exchange
  • Properties involved must be business or investment property held for productive use
  • Personal residences are ineligible for 1031 exchange treatment

Selling Investment Property

A like-kind exchange can be an excellent tool that can be used to achieve investment goals. Even in situations where it is impractical to arrange a completely tax-free transaction, a partial like-kind exchange may still reduce the immediate tax consequences of altering your investment holdings.

A well-known, but sometimes overlooked, way to alter investment holdings without paying tax at the time of the transaction is through the use of "like-kind" exchanges. In a like-kind exchange, investment real property is traded for other investment real property. The person transferring one piece of property receives different property, and the basis in the original property generally carries over to the new property and is increased by any boot or cash paid. That way, the gain is deferred while other tax attributes are preserved.

“For commercial property owners, the final bill presents a bigger victory than many expected.”
Keiko Morris
Wall Street Journal

Of particular interest are the flexible features that make a like-kind exchange an especially useful technique. First, properties do not have to be of an identical type to qualify as like-kind. To take a few examples, commercial buildings have been exchanged for unimproved lots, farm land for city lots, and even cooperative housing stock carrying occupancy rights for a condominium interest in the same property. However, only real property qualifies for a like-kind exchange.

Second, properties do not have to be exchanged at the same time. Therefore, it is not necessary to have already located the exchange property to make a like-kind exchange (an important consideration if the end of a tax year is looming). It is sufficient that the exchange property be identified within 45 days after the relinquished property is given up, and that the identified property be received within 180 days. (However, if the tax return due date for the original transfer year occurs before the 180-day period, the identified property must be received on or before the tax return due date.)

Key to the successful execution of a 1031 exchange is a Qualified Intermediary (QI) who is responsible for executing the property acquisitions and transfers and holding exchange funds. The QI will also guide taxpayers involved in the exchange, assist in the preparation of essential documentation and will direct closing officers to ensure proper 1031 exchange procedures are completed.

To illustrate how these exchanges work, consider the following example:
Fred owns an interest in an office building. He bought it six years ago, for $10,000, but today it’s worth at least $100,000. Fred has decided to move to Florida and convert his office building interest into an ownership share in a Florida apartment building. Allison wants to buy Fred’s office building interest, and for tax reasons she wants to own the building interest by December 31. Fred wants to avoid the high tax he would have to pay after a cash sale.

A solution is a tax-deferred like-kind exchange. Fred transfers his building interest to Allison on December 31. Allison agrees to locate and buy a Florida apartment building interest of equal value suitable to Fred. (Allison would be required to put the purchase price in escrow with a Qualified Intermediary so long as Fred has no independent right to the cash.) After Allison finds and buys the Florida property, she transfers it to Fred, and the like-kind exchange is completed.
Provided the 45/180-day rules along with other requirements are satisfied, Fred receives the Florida property tax-free, with the same basis and holding period he had in the office building.

{THE BOTTOM LINE}

Any transaction must be carefully structured. Requirements of effective like-kind exchanges can vary widely. For example, a like-kind exchange involving a related party requires additional consideration. 1031 exchanges are a complex tax and accounting area and the key to a successful result is careful tax planning with a qualified tax professional.

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Melinda Korczynski, CPA, joined our firm in 2012 and earned her CPA certificate in 2010. Read her full bio here. E-mail her at MelindaK@colemanhortoncpa.com.

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