Internal Revenue Code §1031 provides, in relevant part, that no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for an investment if such property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment. If property was acquired on the above described exchange, then the acquiring party’s basis in the new property shall be the same as their basis in the old property minus any cash (or “boot”) received with the exchange.
Basically, if you exchange one investment property for another investment property, you don’t have to realize a gain on the sale or pay the taxes that would have been due if you had realized a gain on the sale.
The rationale for this treatment is that the new property is substantially a continuation of the old investment still unliquidated.Reg §1.1002(c).
What remains the same are the standards to be met to properly qualify for, and execute, a like kind exchange. In a nutshell:
- Both the property given up and the property received must be held for productive use in a trade or business or for investment;
- The property must be Real Property not held for personal use or as inventory;
- The exchanged properties must be of “like-kind” meaning they must be used for trade or business although the trade or business for the acquired property need not be the same as the trade or business of the exchanged property;
- If not received immediately, the new property must be identified in writing within 45 days after the sale of the original property and the new property must be received within 180 days of the sale of the original property or the due date for the tax return year in which the sale of the first property occurred, whichever comes first.
So long as the above factors are met, a 1031 exchange has taken place and the taxpayer need not pay taxes on any gain realized on the sale of the original property. Further, the taxpayer’s basis in the new property is the value of the original property on date of sale.
The cleanest version of this type of exchange would be a property-for-property exchange. Practically speaking, this type of arrangement isn’t likely to occur all that often and the courts have recognized as much. The 1979 opinion of the Ninth Circuit US Court of Appeals in Starker v. United States provided, amongst other things, that while the “underlying purpose” of section 1031 is not clear, “[t]he legislative history reveals that the provision was designed to avoid the imposition of a tax on those who do not ‘cash in’ on their investments in trade or business property.” The Court went on to declare that an arrangement whereby a property is sold in exchange for a credit to later purchase a similar property for similar use was within the scope of what the legislature intended to protect against taxation through section 1031 and qualified as a “like-kind exchange” for purposes of not recognizing a gain.
The Court in Starker articulated a simple truth: If you haven’t gained control of your money or “cashed in” on your investment, you haven’t realized a gain. The introduction of a qualified intermediary allowed investors more flexibility with how they structured exchanges of their investment properties. A “qualified intermediary,” as defined by Treasury Regulation §1.103(k)-1, is a person who i) is not the taxpayer, their agent, their family, or their business partner, and ii) enters into an exchange agreement whereby the qualified intermediary acquires the first property from the taxpayer, transfers the property, acquires the replacement property, and transfers the replacement property to the taxpayer. Under this arrangement, so long as the 45-day and 180-day timelines are met, a taxpayer can effect a 1031 exchange without directly exchanging property for property.
Reporting the Exchange
As with most circumstances involving tax liability, 1031 exchanges must be reported to the IRS. A taxpayer who has completed a 1031 exchange must complete and submit a Form 8824 for the tax year in which the original property was sold regardless of when the replacement property was acquired.
When discussing 1031 exchanges, people often presume that it is a “tax-free” exchange. Let there be no confusion: there is nothing “tax-free” about this type of exchange. A better way to think of it is tax deferred. The taxpayer will owe taxes on their gain upon sale of the acquired property presuming they do not conduct another 1031 exchange and presuming that the 1031 exchange is still a viable option.
The existence and application of the 1031 exchange is also very much in flux at these times. The nation is coming up on election season and with recent, continued financial strain on the government, both parties are tinkering with ideas to curtail or limit the application of 1031 exchanges.
Navigating the taxable income waters can be tricky and, as always, a taxpayer should speak with their tax professional to ensure that their real property exchange qualifies for 1031 treatment and is properly documented