Nuts and Bolts of an Internal Revenue Code Section 1031 Like-Kind Exchange

Taxpayers have for decades been utilizing U.S. Internal Revenue Code (the Code) section 1031 to avoid current taxation on the gains from the sale of their investments in real property. The Tax Cuts and Jobs Act of 2017 eliminated the previously available tax benefit of §1031 respective to personal property. Currently, only real property held for investment or real property held for productive use in a trade or business is accorded the possibility of non-recognition of gain treatment under §1031.

Under §1031(a), no gain or loss is recognized on the transfer of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind, also is held either for productive use in a trade or business or for investment. Note that this tax non-recognition treatment simply “defers”, or pushes off to the future, the recognition of federal income tax on the gain realized from the prior transfer of the real property where the other requirements of §1031 would be satisfied. In other words, §1031 does not, standing alone, operate to “exempt” the otherwise realized-yet-unrecognized gain. For example, in a case in which an investment properly exchanged-for as replacement property under §1031 would be later transferred to a third party in a transaction not invoking §1031 treatment, such transfer would trigger the then current recognition of income tax on the gain previously realized yet not recognized in the prior §1031 exchange. The foregoing being noted, certain federal income tax principles, such as the “step up” in the income tax basis of a decedent’s property to its fair market value at the decedent’s date of death, could apply and result in a §1031 deferred gain arising during that decedent’s life being an effective exemption from income tax on such previously-deferred gain after death. Such succession planning topic is outside the scope of this article, yet worthy of keeping in mind for possible further consideration.

What are the requirements for a valid §1031 exchange?

1. The real property intended to be exchanged for (the “replacement property”) must be identified in prescribed documentation within 45 days of the date of the transfer of the property disposed of (the “relinquished property”);
2. The replacement property must be received within the earlier of (i) 180 days after the transfer of the relinquished property or (ii) within the due date, including extensions, of the tax return of the exchanging taxpayer for the taxable year of the relinquishment transfer.
3. The transfer of the relinquished property must be channeled through an independent “qualified intermediary” (QI), which QI cannot be the agent or attorney of the taxpayer, and which QI must also receive the cash paid by the purchaser of the relinquished property; correspondingly, such QI also must be the party receiving delivery of the replacement property on behalf of the exchanging taxpayer at completion of the transaction. Such sequence can also be inverted.
4. The relinquished property and the replacement property must be of a “like-kind.” The non-recognition treatment in a purported §1031 tax deferred exchange will not be available where the exchange of one kind or class of property is for another kind or class of property. Under §1031 property held for productive use in a trade or business may be exchange for property held for investment, and vice versa.
5. The exchanging taxpayer can be an entity or an individual, so long as, generally, they are the same party on both sides of the transaction. An interest in a partnership which makes an election under §761(a) to be excluded from federal income tax treatment as a partnership is treated as an interest in each of the assets of the partnership and not as an interest in a partnership.
6. Real property held in a trade or business or for investment located offshore can be exchanged for offshore property of a like-kind used in a trade or business or to be held for investment, and domestic real property used in a trade or business or held for investment can be exchanged under §1031 for domestic real property used in a trade or business or to be held for investment. Real property located in the U.S. and real property located outside the U.S. are by definition not property of a like kind.

What is real property and what kinds of real property are of a like-kind for purposes of a §1031 exchange?

Real property for purposes of §1031 means land and improvements to land, unsevered natural products of land, and water and air space superjacent to land. Inherently permanent structures means buildings or other structures permanently affixed to real property and that will ordinarily remain affixed for an indefinite period. Property that is real property under state and local law is also real property for purposes of §1031. Unsevered natural products of land include growing crops, plants and timber, mines, ores, minerals.  Such items cease to be real property once severed from land.

Assuming an exchanging taxpayer is not a dealer in real estate (i.e., where the property would be considered “inventory”), a §1031 exchange may include a taxpayer’s exchange of city real estate for a ranch or farm, or the taxpayer’s exchange of a leasehold of a fee with 30 years or more to run for real estate, or exchanges of improved real estate for unimproved real estate; or the exchange of investment property and cash for investment property of a like kind.

What happens if in addition to like-kind real property a transferring taxpayer receives money or other non-like kind property?

If an exchange would be within the provisions of 1031(a) except that the property received in exchange consists not only of real property of a like-kind amenable to being received without the recognition of gain, but also of other property or money, then the gain, if any, realized by the recipient taxpayer will be recognized, but not more than the sum of such money and value of such other property.

Are there costs in addition to those typically incurred to conduct a §1031 exchange?

Yes, there conventionally are fees incurred by a taxpayer in structuring and completing a §1031 exchange, including possible incremental attorneys’ fees, the fees charged by the qualified intermediary and the tax preparer’s reporting of the transaction at tax return time.  Accordingly, from a business decision perspective, the size of the gain and its associated federal income tax liability not presently recognized (and, therefore, the time value of money on the opportunity cost of funds not otherwise owing for the tax year of the transfer) must be weighed against the projected transaction costs involved.

Conclusion:

In our globally-recognized, recently rapidly appreciating real estate marketplace, an investor/taxpayer’s facing of the corresponding taxable gain inherent with the disposition of that investment, standing alone, commonly justifies employment of the §1031 like-kind exchange technique. Such technique, when potentially combined with the particular estate and succession planning initiatives of the investor/taxpayer, could escalate the decision to pursue a §1031 exchange transaction as a component of a tax-wise, lawful income tax and estate succession planning strategy.

Peter P. Lindley, P.A. has represented clients in the conduct of both domestic and international §1031 exchange transactions and in connection with both commercial and residential real properties. Please contact us should wish to discuss your particular situation and the potential application of this tax-wise approach to lawful U.S. income tax planning.