Section 1031 Like-Kind Exchanges of Real Estate with Income Tax Benefits Protected by U.S. Tax Cuts and Jobs Act of 2017

Real estate investors might want to unload one property and replace it with another, but selling such an appreciated property can result in gain and a tax hit.

1031 of the Internal Revenue Code still allows an investor to postpone a tax bill by arranging for a deferred like-kind exchange.  Such maneuvers have helped real-estate investors get and stay rich.

Like-kind real estate exchange basics

An investor can arrange for tax-free real property swaps as long as the relinquished property (the property you unload in the swap) and the replacement property (the property you receive in the swap) are of like-kind.

To avoid any current taxable gain, however, you also must avoid receiving any “boot” – which is cash and property that’s dissimilar to the relinquished property. When mortgaged properties are involved, boot also includes the excess of the mortgage on the relinquished property (the debt you get rid of) over the mortgage on the replacement property (the debt you assume).

If you receive any “boot”, you are taxed currently on gain equal to the lesser of: (1) the value of the boot or (2) your overall gain on the transaction based on fair market values. So if you receive only a small amount of boot, your swap will still be mostly tax-free (as opposed to completely tax-free). On the other hand, if you receive lots of boot, you could have a big taxable gain.

The easiest way to avoid receiving any boot is to swap a less-valuable property for a more-valuable property. That way, you’ll be paying “boot” rather than receiving it. Paying boot won’t trigger a taxable gain on your side of the deal.

The untaxed gain in a like-kind swap can get rolled over into the replacement property, which remains untaxed until sale of the replacement property in a taxable transaction.

What is “like-kind” real property?

When it comes to real estate, the IRS has a definition of “like-kind property” – and an investor can swap improved real estate for unimproved real estate, a strip center for an apartment building, a boat marina for a golf course, and so forth. However, you can’t swap real property for personal property without triggering taxable gain. For example, you can’t swap a building for an airplane. Finally, you can’t swap property held for personal use, such as your home or boat. Nor can you swap inventory, partnership interests, or investment securities. The vast majority of tax-free like-kind exchanges involve investment real estate.

The IRS previously clarified that even undivided fractional ownership interests in real estate (like tenant-in-common ownership interests) can potentially qualify for like-kind swaps.  So if the investor needs not to receive an entire commercial building as the replacement property in order to complete your tax-free exchange.  The real estate investor can instead receive an undivided fractional ownership interest in the property. (Source: IRS Revenue Procedure 2002-22).

Deferred like-kind real estate exchanges

It is difficult for the investor who wants to make a like-kind swap to locate another party who owns suitable replacement property and who also wants to make a like-kind swap rather than a cash sale.  Such deferred exchanges can also qualify for tax-free like-kind real estate exchange treatment.

Under the deferred exchange rules, the real estase investor is not required to make a direct and immediate swap of one property for another.  Instead, the investor can in effect sell the relinquished property for cash, park the sales proceeds with an intermediary who effectively functions as your agent, locate a suitable replacement property later, and then arrange for a tax-free like-kind exchange by having the intermediary buy the property on behalf of the investor.

Here’s how a typical real estate deferred swap works.

One:  The investor transfers the relinquished property (the property you want to swap) to a qualified exchange intermediary (whose role is to facilitate a like-kind exchange for a fee which is usually based on a sliding scale according to the value of the deal).

Two:  The intermediary arranges for a cash sale of your relinquished property. The intermediary then holds the resulting cash sales proceeds on your behalf.

Three:  The intermediary then uses the cash to buy suitable replacement property which you’ve identified and approved in advance.

Four:  Finally, the intermediary transfers the replacement property to you to complete the like-kind exchange.

From the real estate investor perspective, this series of transactions counts as a tax-free like-kind swap.  The investor winds up with like-kind replacement property without ever having actually seen the cash that greased the skids for the underlying transactions.

What if the real estate investor still owns the replacement property at time of death?

Under our current federal income tax rules, any taxable gain would be completely washed away thanks to another favorable provision that steps up the tax basis of a deceased person’s property to its date-of-death value.  So taxable gains can be postponed indefinitely with like-kind swaps and then erased if you die while still owning the property. Real estate fortunes have been made in this fashion without sharing with Uncle Sam.

Like-kind 1031 exchange swaps of real estate property can get complicated, and potential tax advantages are big.

Such like-kind exchanges of real estate property under Section 1031 have been protected by the Tax Cuts and Jobs Act of 2017.

Two Important Requirements

In order for your deferred exchange to qualify for tax-free swap treatment, you must meet two important requirements.

First:  You must unambiguously identify the replacement property before the end of a 45-day identification period. The period commences when you transfer the relinquished property. You can satisfy the identification requirement by specifying the replacement property in a written and signed document given to the intermediary. In fact, that document can list up to three different properties that you would accept as suitable replacement property.
Second:  You must receive the replacement property before the end of the exchange period, which can be no more than 180 days. Like the identification period, the exchange period also commences when you transfer the relinquished property. The exchange period ends on the earlier of: (1) 180 days after the transfer or (2) the due date (including extensions) of your federal income tax return for the year that includes the transfer date. When your tax return due date would cut the exchange period to less than 180 days, you can simply extend your return. That restores the full 180-day period.

The major change to Section 1031 by the 2017 Tax Cuts and Jobs Act is the complete repeal of personal property exchanges.

The Income Tax Code section now refers exclusively to real estate assets, and has been retitled, “Exchange of real property held for productive use or investment.”  Real estate exchanges are subject to the same rules and regulations as under previous law. The 45 day identification and 180 day exchange periods remain unchanged, as does the role of the Qualified Intermediary.  All real estate in the United States, improved or unimproved, also remains like-kind to all other domestic real estate.  Foreign real estate continues to be not like-kind to real estate in the U.S.

Personal property assets that can no longer be exchanged include intangibles, such as broadband spectrums, fast-food restaurant franchise licenses and patents; aircraft, vehicles, machinery and equipment, railcars, boats, livestock, artwork and collectibles.  Transition rules permit a personal property exchange to be completed in 2018 if either the relinquished property was sold or the replacement property was acquired by the taxpayer during 2017.

Source of some information for this post is an article at MarketWatch.com.  This is the providing information only and is not the providing of legal services or income tax services.  If you are a real estate investor and need more information about 1031 like-kind exchanges of real estate, you should consult with an experienced real estate broker, certified public accountant or real estate attorney in your area.

“Section 1031 Like-Kind Exchanges of real estate property with Income Tax Benefits Protected by U.S. Tax Cuts and Jobs Act of 2017”

About Harrison K. Long

Real estate and business attorney. CA State Bar Association attorney member #69137. Professional real estate representative, REALTOR®, GRI, Real estate broker, CALBRE #01410855. Broker associate, HomeSmart Evergreen Realty, Irvine, CA. Providing real estate legal information and services for property owners, estate trustees, executors and administrators, fiduciaries, bankers, investor group managers, with their best decisions about homes and real estate. Orange County REALTORs® (member and prior service on its board of directors). "Realtor of the Year 2016" award by the Orange County REALTORs®. California Association of REALTORs® (now serving on its board of directors). National Association of REALTORs® member. Contact by cell or or text at 949-701-2515.
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