2016-Issue 5 – While it is anyone’s guess what tax reform or the Obama Administration’s FY2017 budget will bring for the longstanding Section 1031 tax-free exchange, as we begin a new year it may be time to dust off the mechanics of this taxpayer-friendly provision. Enacted almost 100 year ago, Section 1031 provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment. While the application of Section 1031 does not actually eliminate tax, it does create a valuable deferral that allows taxpayers to efficiently reinvest their proceeds as they continue their economic investment in a similar asset. Will this deferral be repealed, significantly lessened or materially altered otherwise?
Last year’s budget suggested a $1 million capital gain deferral from the exchange of real property, with an effective date for exchanges completed after December 31, 2015. The proposed budget would have also disqualified art and collectible exchanges and the aggregation of multiple properties exchanged by related parties. If a similar proposal is put forth, and is passed into law, perhaps exchanges will at least be unchanged for the rest of the year. Given the length of time generally necessary to execute a proper exchange, it is not too early to consider replacement property if you are inclined to sell. The rules and mechanics may be complex, but the concept is generally straightforward. Like many areas of the tax code, nuanced planning techniques abound, but this article is meant to address the high-level issues.
Three essential conditions must be met for nonrecognition of gain or loss:
- Both the property you transfer and the property received from the other taxpayer must be “property held for the productive use in a trade or business or for investment.” Note that a transfer of business property for investment property or the other way around is permitted, but not personal use property, property held primarily for sale or partnership interests (although tenant-in-common interests may be permissible).
- There must be an “exchange.” To constitute one, “the transaction must be a reciprocal transfer of property, as distinguished from a transfer of property for a money consideration only.” Note that a transfer or receipt of money together with qualifying like-kind property will not disqualify the exchange, but it may produce some gain recognition.
- The properties must be “like kind.” Note that while there are numerous assets that are deemed “like kind,” livestock of different sexes do not qualify.
A number of tax and investment goals may be accomplished by exchanging assets while deferring federal and state capital gains, including depreciation recapture; buying newer or better-performing property; diversifying or consolidating one’s real estate portfolio since multiple properties can be acquired in one exchange; changing the location of your assets if you’ve moved; and perhaps estate planning, as the property could get a step-up in basis upon death.
Types of Exchanges
- Two-party exchange: direct, even-up, simultaneous. Not particularly common.
- Two-party deferred exchange (Starker): the transfer of properties does not take place simultaneously but it is similar to a basic two-party exchange. Still challenging to find taxpayers who want each other’s property.
- Three-party deferred exchange: a property owner transfers property to one taxpayer, then uses the proceeds of that transfer to obtain replacement property from a different taxpayer. Generally the most common exchange.
- Reverse (Starker) exchange: a property owner first obtains a new property from one taxpayer, and then afterward transfers a different property to a different taxpayer.
- Build-to-suit exchange: a property owner transfers property to one taxpayer and then acquires another property after it has been improved from a different taxpayer, using the funds from the transfer of the first property. Also referred to as construction or improvement exchanges.
Basic Exchange Rules
- Replacement property must be identified within 45 days of the closing and transfer of the relinquished property. Identification falls under two rules, a three-property rule or a 200 percent rule. The former permits the identification of three properties regardless of their fair market value, and the latter permits the identification of any number of properties, provided that their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of the relinquished properties.
- Replacement property must be acquired within the earlier of 180 days of the closing and transfer of the relinquished property, or the due date, with extensions, of the taxpayer’s income tax return for the taxable year in which the transfer of the relinquished property occurs.
- Money or other property not qualifying as “like kind” property, referred to as boot, may give rise to taxable gain if part of an exchange.
- Liabilities such as mortgages transferred or received in an exchange are part of amounts realized and may result in taxable boot. Note that mortgages may be netted if both exchange assets are mortgaged.
- “Like kind” is broadly defined in the regulations as to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under Section 1031(a), be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.
- Real or constructive receipt of exchange proceeds before both ends of the exchange are completed may result in a sale and taxable gain. Qualified intermediaries are often used to help facilitate exchanges.
- Rule of thumb to avoid taxable gain is to exchange up in value (and liabilities), not down. Note that when assumed liabilities exceed transferred liabilities, taxable boot may be decreased if that taxpayer transfers money or other property as well.
- Exchanging for an asset of lesser value does not necessarily mean the entire 1031 transaction has failed, but note that it also does not mean that only a pro rata amount of gain recognized will be realized — i.e., gain recognition comes first.
- Basis of replacement property received equals the basis of the property transferred — i.e., substituted basis. Further adjustments may be necessary for cash received or paid and for any gain or loss recognized.
- Recovery periods and depreciation methods may not be the same for the exchanged and replacement property. While the rules are generally IRS-friendly, some relief may exist under Section 168 by making an election out, if applicable.
- Holding periods are tacked to the original purchase date.
- Related-party exchanges are allowed, although subject to a two-year holding period after the exchange.
Carefully following these exchange rules and other relevant guidelines is paramount to executing a proper like-kind exchange. Indefinite deferral of taxes allows taxpayers to save their cash while focusing on their business and investment objectives. While the form of such transactions takes on many different shapes and sizes, taxpayers must carefully plan in order to meet all prescribed deadlines to maintain the proper form.
Alvarez & Marsal Taxand Says:
Guidance from the IRS and the courts has continued steadily throughout the years, causing the nuances to successfully completing like-kind exchanges to abound as taxpayers pursue indefinite deferral of taxation. Will this tremendously valuable Code section continue to allow for the potential of full deferral, or at least an amount material enough to incentivize taxpayers to enter into these complicated arrangements? Many of those in the real estate industry and others spend significant time evaluating the possibilities of the like-kind exchange, some of whom depend upon performing exchange services for a living. Will the increased scrutiny on the real estate industry, perhaps as seen most recently by the President’s Consolidated Appropriations Act restricting tax-free REIT spinoffs, continue with significant reforms to Section 1031? While many professionals in taxation, economics and industry have written about the economic harm that a repeal or material change may bring, now may be an appropriate time to revisit your awareness and understanding of the rules as you consider executing an exchange.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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