Defer Capital Gains using Like-Kind Exchanges

Posted on September 1, 2015 by Oozle Media

A like-kind exchange, also called a Section 1031 exchange, may allow you to defer recognizing gain when you dispose of qualifying investment or business real property and acquire other qualifying real property. The tax is deferred, not eliminated, and the transaction has to follow specific IRS requirements and timelines to qualify.

At Lightheart, Sanders and Associates, our tax team helps investors and business owners in Mississippi and South Carolina plan 1031 exchanges, coordinate with qualified intermediaries, and handle the required tax reporting.

What is a Section 1031 like-kind exchange?

A Section 1031 exchange allows you to exchange real property held for investment or business use for other qualifying real property and defer recognition of some or all of the gain that might otherwise be taxable.

The properties do not need to be identical in type. For example, you may be able to exchange an apartment building for a shopping center, or undeveloped land for an office building, as long as both properties meet the requirements for business or investment use.

Generally, real property located in the United States can be like kind to other qualifying U.S. real property, whether the properties are improved or unimproved. U.S. real property and real property located outside the United States, however, are not considered like kind under Section 1031.

There is no set limit on how many qualifying 1031 exchanges you can complete, so it is possible to continue rolling deferred gain into new properties. Keep in mind that the gain is deferred, not forgiven. You will also need to track your basis in the replacement property so the deferred gain can be calculated correctly when it is eventually recognized.

What property qualifies for a 1031 exchange?

• Real property held for investment: Rental homes, apartment buildings, commercial buildings, and raw land may qualify when they are held for investment or productive use in a trade or business.
• Like-kind replacement property: The replacement property does not need to be the same type of real estate. In general, qualifying U.S. real property can be exchanged for other qualifying U.S. real property.
• Property that does not qualify: Real property held primarily for sale, such as certain dealer property, does not qualify. A home held solely for personal use also does not qualify for Section 1031 treatment.

An important change took effect in 2018. Section 1031 is now generally limited to real property. Assets such as vehicles, artwork, collectibles, and most other personal or intangible property no longer qualify for like-kind exchange treatment.

The rules defining real property can become technical, particularly when an exchange involves equipment, fixtures, or certain rights associated with real estate, so it is important to review the specific assets involved before assuming they qualify.

What happens if the properties you are exchanging are not equal in value?

A 1031 exchange does not require the relinquished and replacement properties to have exactly the same value. However, receiving cash, non-like-kind property, or certain net debt relief as part of the transaction may cause some of your gain to become taxable.

This taxable value is commonly referred to as boot.

For example, if you sell a qualifying property and receive cash that is not reinvested through the exchange, you may have to recognize gain up to the amount of cash received. Similarly, receiving non-like-kind property can result in recognized gain.

On the other hand, paying additional cash or taking on additional debt to acquire a more expensive replacement property is not, by itself, taxable boot to you.

Most deferred exchanges use a qualified intermediary rather than having the property owner receive and reinvest the sale proceeds directly. The qualified intermediary holds the proceeds from the relinquished property and uses them as part of the acquisition of the replacement property.

This structure is important because taking actual or constructive possession of the sale proceeds can cause the transaction to lose its eligibility for tax deferral.

Under the right circumstances, you do not need to arrange a direct one-for-one property swap. You can transfer one property, have the proceeds held by a qualified intermediary, and acquire a different qualifying replacement property within the required timeframes.

Does an existing mortgage affect a 1031 exchange?

Yes. Mortgages and other liabilities can affect how much gain is recognized in a 1031 exchange.

If the debt associated with your relinquished property is greater than the debt you assume on the replacement property, the reduction in liability may be treated as money received for purposes of calculating taxable gain.

For example, suppose the property you relinquish is subject to a $200,000 mortgage and the replacement property is subject to a $150,000 mortgage. The $50,000 reduction in debt may factor into the amount treated as received in the exchange.

However, the calculation does not stop there. Cash you contribute to the exchange and certain liabilities you assume may offset debt relief. Because mortgage and liability calculations can significantly affect the tax result, they should be reviewed as part of the exchange planning process rather than after the transaction closes.

What are the deadlines for a 1031 exchange?

A deferred Section 1031 exchange runs on a strict schedule.

1. Identify replacement property within 45 days. You generally must identify your potential replacement property in writing within 45 days after transferring the property you are giving up. The identification must meet IRS requirements.
2. Complete the exchange within the required exchange period. You generally must receive the replacement property by the earlier of 180 days after transferring the relinquished property or the due date of your tax return, including extensions, for the year in which the transfer occurred.
3. Set up the qualified intermediary before the sale. For a typical deferred exchange, your qualified intermediary and exchange agreement should be in place before you close on the relinquished property. Receiving or gaining unrestricted access to the sale proceeds yourself can disqualify the exchange.

These deadlines generally cannot be extended simply because a closing is delayed or an unexpected problem arises. Limited relief may be available in certain situations, including qualifying federally declared disasters, but you should not assume an extension applies without confirming it.

Advance planning is one of the most important parts of a successful 1031 exchange. Waiting until after a property has already been sold can eliminate options that would otherwise have been available.

Can you use a 1031 exchange for a vacation home?

A property used solely as a personal vacation home generally does not qualify for Section 1031 treatment. However, a dwelling unit may qualify when it is genuinely held for investment or business purposes.

The IRS also provides a safe harbor for certain dwelling units under Revenue Procedure 2008-16.

For a vacation property you are giving up in an exchange, the safe harbor generally requires you to have owned it for at least 24 months immediately before the exchange. During each of the two 12-month periods before the exchange, the property generally must be rented to others at a fair rental price for at least 14 days, and your personal use cannot exceed the greater of 14 days or 10 percent of the number of days it is rented at a fair rental price.

A similar safe harbor applies when the vacation property is the replacement property. You generally must own it for at least 24 months after the exchange. During each of the two 12-month periods after the exchange, it generally must be rented at a fair rental price for at least 14 days, while your personal use remains within the permitted limits.

These safe harbor rules are separate from the tax rules governing the sale of a primary residence.

If you sell a qualifying principal residence, you may be eligible to exclude up to $250,000 of gain, or up to $500,000 for certain married couples filing jointly. Eligibility depends on meeting the applicable ownership, use, and other requirements.

How do you report a 1031 exchange to the IRS?

You report a Section 1031 exchange on IRS Form 8824, Like-Kind Exchanges, with your tax return for the year in which the exchange occurs.

The form reports information about the properties involved, important exchange dates, related-party transactions when applicable, liabilities, property received, and the calculation of recognized and deferred gain.

If an exchange is structured or reported incorrectly, some or all of the gain that was expected to be deferred may instead become taxable. Penalties and interest may also apply in some circumstances.

Like-kind exchanges can be valuable planning tools, but the rules surrounding timing, property eligibility, debt, basis, and reporting can make them more complicated than they first appear.

We work with real estate investors and business owners across Mississippi and South Carolina to plan exchanges, coordinate with qualified intermediaries, and properly report transactions on Form 8824.

Next step: If you are considering a Section 1031 exchange or want to talk through whether one makes sense for your situation, reach out to our tax planning services or contact us directly before you sell.

Frequently asked questions

What is boot in a 1031 exchange?

Boot generally refers to cash, non-like-kind property, or certain net debt relief you receive as part of an exchange. Receiving boot can cause you to recognize some gain even when the rest of the transaction qualifies for Section 1031 deferral.

How long do I have to complete a 1031 exchange?

You generally must identify replacement property within 45 days after transferring your original property. You must receive the replacement property by the earlier of 180 days after that transfer or the due date of your tax return, including extensions, for the year of the transfer. Limited IRS relief may apply in certain circumstances, such as qualifying federally declared disasters.

Does a 1031 exchange eliminate capital gains tax?

No. A 1031 exchange generally defers recognition of qualifying gain rather than eliminating it. Your basis in the replacement property reflects the deferred gain, which can affect the tax consequences of a later sale or exchange.

Can I do a 1031 exchange with personal property like vehicles or artwork?

Generally, no. Since 2018, Section 1031 has been limited to qualifying real property. Vehicles, artwork, collectibles, and most other personal or intangible property generally do not qualify. Certain assets or interests can have special treatment under the rules defining real property, so specific situations should be reviewed individually.

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