Like-kind exchanges are regulated by Internal Revenue Service Code Section 1031, and sometimes they are referred to as Section 1031 exchanges. For tax purposes, these transactions are not recognized as a sale of property, but rather as a trade of one investment in real property for another. Real estate investors often use like-kind exchanges as part of their tax liability management strategy, but these transactions are complex and potentially full of pitfalls.
If you’re thinking about moving forward with a like-kind exchange – or any other complex real estate transaction for that matter – be sure to get the help of a good real estate attorney. The skilled real estate attorneys at M&A Law Firm have been providing commercial real estate solutions for clients in the Chicago-area for years, and they’re ready and waiting to help your next deal go through without a hitch.
How Section 1031 Defines Like-Kind Exchanges
Like-kind exchanges only apply to investment and business property and trades are fairly relaxed. Residential properties, inventory, securities, trust certificates, corporate stock, or partnership interests cannot be exchanged under Section 1031. Rather, by definition a like-kind real property exchange involves a trade of real properties within the United States that are the same in nature or character, even if they have different qualities. So, for example, two lots of the same approximate size, value, and location could be exchanged under Section 2031 even if one was improved and the other unimproved.
A like kind exchange can involve the swap of one apartment building in exchange for another apartment building, or a vacant lot of land for a commercial building. Exchanges can also be between multiple properties. Commercial property swaps within a party of three or more are referred to as Starker Exchanges.
Tax Benefits of Like-Kind Exchanges
Most trades are taxable as sales, but the Section 1031 requirements allow a tax-free or limited tax payment at the conclusion of a like-kind exchange. There are no limits on how often an investment can be traded for another, so like-kind exchanges allow investments to continue to grow over time tax-deferred. However, once an investment is sold for cash, then the investor will be required to pay taxes.
When an investment property is sold, the seller is responsible for paying the capital gains tax on the sale. Even if the seller was not the original buyer, selling the property can cost most than it makes in the sale. Section 1031 allows a trade in properties without requiring the seller to pay a tax obligation, until the investor ultimately cashes out. Until then, profits from commercial properties can move from one investment to the next so long as the like-kind exchanges continue. However, there’s a catch: the price and new loan must be the same or higher for the acquired property.
How to Move Forward With a Like-Kind Exchange
To meet the requirements of the like-kind exchange, the seller must inform the intermediary within 45 days which property is being exchanged and acquired. Under Section 1031, once the sale of a property occurs a qualified intermediary must receive the cash from the sale, similar to an escrow arrangement. A qualified intermediary is a third party entity or person that facilitates a Section 1031 exchange, often a trusted real estate attorney. The property sale for both properties must also close within 180 days of each other in order to qualify for valuable tax benefits.
Once the exchange is closed, no taxes are due so long as the purchase price and the sale price of the exchanged properties result in a net profit of zero or a net loss. However, there are several potential pitfalls and complexities associated with like-kind exchanges that have tripped up even the most sophisticated real estate investors.
Complexities and Pitfalls in Like-Kind Exchanges
Like-kind exchanges may be common, but they are also quite complex and potentially riddled with pitfalls. Having a good real estate attorney – like any of the staff attorneys at M&A Law Firm – on your side can help you avoid some costly pitfalls and missed opportunities
For example, it’s easier than you may think to trigger unintentional tax liability during the course of a like-kind exchange. For example, if there is cash left over after the investor acquires the replacement property, the qualified intermediary will return it to the investor at the end of the 180 days. That left-over cash is called the boot. The boot is taxed as a partial sale proceed from the sale of the property. Additionally, if the mortgage remaining on the newly acquired property that is less than the mortgage remaining on the sold property, the difference in remaining mortgage is treated as gained income, classified as boot, and is taxed.
There are also special rules that apply to like-kind exchanges. Consider the example of depreciation recapture, which occurs when an exchange occurs for property that sells for more than its depreciated value. The depreciation amount will be included in the taxable income. This can be a difficult provision of the law that is best addressed with professional help.
Certain properties, like mutual ditches, reservoirs or irrigation stock, are eligible for non-recognition of gain or loss as like-kind exchanges. Personal or intangible property, like machinery, equipment, vehicles, artwork, collectibles, patents, or other intellectual property and business assets, do not qualify as non-recognition.
There have been also some recent changes in tax laws affecting how, when, and under what circumstances commercial real estate investors can carry out like-kind exchanges. The recent Tax Cuts and Jobs Act has a transition rule permitting 1031 exchanges of qualified personal property. However, a limitation applies if real property was sold or the replacement property was acquired by Dec. 31, 2017.
If you’re considering a like-kind exchange, don’t be discouraged by how complex these transactions can be. Instead, contact your local real estate attorney. A good real estate attorney can help make sure your like-kind exchange is compliant and efficient, avoiding all potential legal pitfalls along the way.
