A 1031 exchange, named after section 1031 of the U.S. Internal Revenue Code, is a way to postpone capital gains tax on the sale of a business or investment property by using the proceeds to buy a similar property. It is also sometimes referred to as a “like-kind” exchange.
The like-kind exchange rules are limited to real property that is not held primarily for sale to customers. Exchanges of personal property and intangible property, such as exchanges of machinery, equipment, vehicles, intellectual property, artwork, and other intangible business assets do not qualify for nonrecognition of gain or loss as a like-kind exchange.
What is Real Property?
Real property is defined as land and improvements to land, unsevered natural products of land, and water and air space superjacent to land. It also includes an intangible interest in real property such as fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, stock in a cooperative housing corporation, land development rights, or similar interest.
What is Like-kind Property?
The term like-kind refers to the nature or character of the property and not to its grade or quality. Although the term was intended to be interpreted broadly, limitations exist. One kind or class of property cannot be exchanged for property of a different kind or class. Real estate can be exchanged only for other real estate. Real estate includes buildings and land as well as various real estate interests, such as co-op units. It does not matter if the real estate is improved or unimproved. Thus, unimproved land can be exchanged for an apartment house.
Purpose of Holding Property
To qualify for nonrecognition treatment, both the property exchanged and the property received must be real estate held either for the productive use in a trade or business or for investment. Like-kind exchanges can include business for business, business for investment, investment for business, or investment for investment property. Property held for personal use, inventory, personal property, and partnership interests do not qualify under the like-kind exchange provisions. Securities (e.g., stocks and bonds), even though held for investment, do not qualify for like-kind exchange treatment. In addition, real property held by a developer primarily for sale (as opposed to held for productive use in a trade or business or for investment) does not qualify.
Exchange Requirement Must Be Met
The transaction must involve a direct exchange of property to qualify as a like-kind exchange. An exchange occurs when a taxpayer conveys property (i.e., relinquished property) to the same party from whom the taxpayer acquires property (i.e. replacement property). If a taxpayer conveys property to a purchaser and acquires replacement property from someone other than the purchaser (even if the sale and purchase close simultaneously), an exchange has not occurred, and the taxpayer must recognize any realized gain for tax purposes. However, the regulations allow the use of a qualified intermediary to accommodate multi-party exchanges. A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other formal relationship with the parties exchanging property.
Deferred Exchanges – Multi-Party Exchanges
A deferred exchange is one in which property received in the exchange (replacement property) is not received immediately upon the transfer of property given up (relinquished property). The deferred exchange rules are the result of the Starker case, which first allowed exchanges that were not simultaneous.
Reg. 1.1031(k)-1 provides rules governing deferred exchanges. The two primary requirements to qualify a deferred exchange as a like-kind exchange are that (1) the replacement property must be identified before the end of the 45-day identification period and (2) the identified property must be transferred before the earlier of the 180-day or return due date exchange period [Reg. 1.1031(k)-1(b)].
This article points out some of the basics of doing a tax free exchange under IRC Section 1031. Please call our office to discuss further or to see if it could work in your situation.
Article Submitted by Richard H. Pollard, CPA