Section 1031 of the Internal Revenue Code, 26 U.S.C. § 1031, allows taxpayers to defer tax recognition of what would otherwise be considered a taxable capital gain when they exchange certain types of property for other property. This section of the law allows taxpayers to avoid paying taxes on profits from sales by showing the IRS that they are re-investing (or “exchanging”) those gains for replacement property. Real estate investors and across the country are reaping the financial benefits of Section 1031’s “like kind exchanges,” but the law and policy surrounding these transactions is far from cut-and-dried. Before claiming any like kind exchange, consult with a skilled real estate attorney in your area. However, understanding the law and policy behind the like kind exchange exemption is a critical starting point for anyone considering buying and selling real estate on a regular basis.
Policy Basis for Like Kind Exchanges
Under a Section 1031 like kind exchange, a taxpayer can defer tax payments on profits from a real estate sale so long as certain requirements are met. Essentially, if an investor purchased new real estate at or near time he or she sold real estate, the proceeds from the sale are untaxed. The idea is that the taxpayer has no “gain” to pay taxes on, since his or property has merely been exchanged for a new property.
Before 1979, taxpayers were required to pay a variety of taxes on all capital gains, regardless of how they intended to use them in the future. That is, if an investor sold a large parcel of land, he or she was required to pay state and federal taxes on her profits. This tax liability accrued even if the property was quickly sold in order to fund a reinvestment in another parcel of land. At this time, only truly simultaneous transactions qualified as like kind exchanges. In 1979, however, the U.S. Court of Appeals for the 9th Circuit decided to allow non-simultaneous sales and purchases to qualify for the like kind exchange exemption. In Starker v. United States, the court held that contracts for future exchanges should be considered the same as a simultaneous exchange. This holding gave rise to the “Starker exchange,” a delayed like kind exchange that is tax exempt so long as it precisely follows specifically-defined rules, especially around timing and declarations.
Qualifying as a Like Kind Exchange
Like kind exchanges can save real estate investors millions in tax liability, but only if they are carried out properly. These process requirements include that the taxpayer identify that he or she is selling a particular property for the purposes of a Section 1031 like kind exchange before closing, identify the replacement property within 45 days after closing, and actually acquire the replacement property within 180 days of closing.
Up until the Tax Cuts and Jobs Act of 2017, many types of personal property – such as securitized properties, but not including stocks and bonds – were entitled to tax deferment under Section 1031. Under the revised tax code, only real estate can qualify as a like kind exchange. Property transferred along with real property (such as tools or equipment) may also be exchanged without being identified within the 45-day period, so long as it is transferred together with the larger real property and does not exceed 15% of the larger property’s fair market value. To qualify as a Section 1031 like kind exchange, the real property exchanged must also be “held for productive use in a trade or business or for investment.” 26 U.S.C.A. § 1031(a)(1). Thus, properties held as inventory or for re-sale by “dealers” are not eligible. Likewise, property held for purely personal use cannot benefit from a 1031 Exchange. Importantly, second homes purchased for appreciation value do not count as investment properties unless they are in fact rented out for value. The proceeds of a sale cannot be in the seller’s possession or under his or her control, otherwise the exchange is disqualified under Section 1031 of the tax code.
Property can only be exempt from federal taxation under Section 1031 if it is of a “like kind.” Cash can never be exempt, as cash is not of like-kind with real property. Therefore, any additional money used to break even on a transaction — commonly known as “boot” — cannot be deferred under Section 1031 and will be taxed as a regular capital gain. Likewise, if the buyer takes on liabilities that exceed those of the seller, the seller will be considered to have “gained” by the amount of the difference, and taxed accordingly. Boot can also include debt reduction, sale proceeds for non-qualifying expenses, non-like-kind property received in the exchange, and money borrowed to close on the replacement property.
Carrying Out a Like Kind Exchange
The rules for Starker exchanges are more particular than simultaneous exchanges. However, because of the proceeds of a Section 1031 sale never touch the seller’s account, most like kind exchanges follow a uniform process. While there is some variation, carrying out a like kind exchange typically proceeds as follows.
First, most people entering like kind exchanges start by hiring a real estate attorney. A good real estate lawyer can prove critical in these transactions, as they can offer legal advice that will help make sure the transaction qualifies under the tax code. In addition, a real estate lawyer can serve as a Qualified Intermediary, which required for a Starker exchange and a common practice for like kind exchanges in general.
Once the parties have the legal advice they need, the seller sells the property. The bill of sale must include a clause in the sale requiring the buyer to cooperate with the Section 1031 process. The closing agent will contact the Qualified Intermediary to exchange the sale documents.
After this step, the parties carry out the actual like kind exchange. This happens at closing, with the Qualified Intermediary named as principal of the sale and subsequent purchase. The exchange agreement must comply with all federal guidelines, but the deed is normally prepared between the taxpayer and the buyer. At this point, no replacement property needs to be identified, but most of the process for carrying out the like kind exchange takes place. Within 45 days of the exchange, the taxpayer must send written identification of the replacement property to the Qualified Intermediary, the seller of the replacement property, or an unrelated attorney pursuant to 26 U.S.C.A. § 1031(a)(3)(A). It must be signed by all involved and, to be safe, hand delivered or sent by certified mail.
When purchasing the replacement property, the same general process applies. A clause should alert the replacement seller of the like kind exchange and require them to comply. The closing statement will identify the Qualified Intermediary as the buyer. When all of these conditions have been satisfied, and before 180 days have passed since the exchange, the Qualified Intermediary will forward the exchange funds to an escrow. 26 U.S.C.A. § 1031(a)(3)(B)(i). The intermediary will also give the taxpayer an accounting document, showing the money coming in from one escrow and going out into another, at all times outside the taxpayer’s hands. To complete the process, the taxpayer files a Form 8824 with the IRS, and so long as all proper care was taken a valuable real estate transaction has occurred with no taxable capital gains accumulating whatsoever.