Internal Revenue Code Section 1031 exchanges have been very popular with taxpayers for many years. This Code section allows taxpayers to defer recognition of gain on the disposition of assets by participating in a like-kind exchange (“LKE”) transaction. There are several rules that a transaction must meet in order to qualify as an LKE. This article covers the basic requirements that must be met in order to defer recognition of gain on disposal of assets until a later date.
The Basics of Section 1031 Exchanges
The first hurdle for an exchange of property to qualify as an LKE is that it must involve qualifying property. Qualifying property includes property used in a trade or business and property held for investment. Property used for personal purposes, stocks, bonds, notes, inventories , and partnership interests do not qualify for a Section 1031 exchange.
In addition to the requirement that the transaction must involve qualifying property, it must also involve like-kind property. Like-kind properties are of the same nature or character, even if they differ in grade or quality. Exchanging real property for real property would qualify as an exchange of like-kind properties; however, exchanging real property for tangible personal property would not qualify as an exchange of like-kind properties. Depreciable tangible personal property needs to be either like-kind or like-class to qualify for LKE treatment. To be considered like-class properties, the assets must be within the same General Asset Class or Product Class.
The basis of the property received in an LKE transaction is generally the same as the adjusted basis of the property given up, however, see the discussion below for partially nontaxable transactions.
A deferred exchange involves an exchange of like-kind assets that is completed over a period of time. Deferred exchanges are more complex, and additional requirements apply. There are time limits to meet in order for a deferred exchange to qualify as a Section 1031 exchange. The first time limit provides a taxpayer 45 days from the date the relinquished property is sold to identify potential replacement properties. The identification must be in writing, signed by the seller, and delivered to a person involved in the exchange (for example, the seller of the replacement property or a qualified intermediary). The second time limit requires that the replacement property must be received and the exchange completed no later than 180 days after the sale of the relinquished property or the due date (with extensions) of the income tax return for the year in which the relinquished property was sold, whichever is earlier. It is important to note that the replacement property will not be treated as like-kind property unless these identification and the receipt requirements are met.
Additionally, if the transferor actually or constructively receives money or unlike property in full consideration for the property transferred prior to the receipt of replacement property, the transaction is treated as a sale rather than a deferred exchange. Using a qualified intermediary (“QI”) can serve as a safe harbor against actual or constructive receipt.
A qualified intermediary is a party who enters into a written exchange agreement with the taxpayer. The written exchange agreement requires that the QI:
1. Acquires the relinquished property from the taxpayer,
2. Transfers the relinquished property,
3. Acquires the replacement property, and
4. Transfers the replacement property to the taxpayer.
The written exchange agreement must expressly limit the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or unlike property held by the QI before the end of the exchange period.
Beware: Some Exchanges are Only Partially Nontaxable
If money or unlike property, referred to as boot, is received in addition to the like-kind property and a gain is realized on the transaction, the exchange will be considered only partially nontaxable. Gain must be recognized equal to the lesser of the boot received or realized gain. If a loss is realized on the transaction, no loss can be recognized.
In calculating the realized gain, any liabilities assumed by the other party must be added to the amount realized. Any liabilities of the other party assumed by the taxpayer should be subtracted from the amount realized.
Example: A taxpayer exchanges business property with an adjusted basis of $32,000 for like-kind property. The property was subject to a $4,000 mortgage. The fair market value (“FMV”) of like-kind property received was $36,000. In addition, the taxpayer received $1,500 in cash and paid $500 in exchange expenses. The other party agreed to pay off the mortgage. How much gain should be recognized on the transaction?
The recognized gain on the transaction is $5,000.
The basis of the property that a taxpayer receives (other than money) in a partially nontaxable exchange is the total adjusted basis of the property given up, with some adjustments. Add to the basis any additional costs incurred and any gain recognized on the exchange. Subtract from the basis any money received and any loss recognized on the exchange. The basis is allocated first to the unlike property, other than money, up to its FMV on the date of the exchange. The remainder is the basis of the like-kind property.
LKE Transactions Involving Related Parties
There are special rules for LKE transactions between related persons. Under the rules, if either party disposes of the property within two years after the exchange, the exchange is disqualified from LKE treatment. In that event, the gain or loss on the original exchange must be recognized as of the date of the later disposition.
Related persons include members of the taxpayer’s family, a corporation owned greater than 50% by the taxpayer, and a partnership owned greater than 50% by the taxpayer. The two-year holding period begins on the date of last transfer of property that was part of the LKE transaction.
As discussed in this article, it is difficult to comply with the rules of Section 1031 related to a like-kind exchange transaction. Although there are many restrictions in place to meet the requirements of a like-kind exchange transaction, the benefits of deferring gain on an exchange can be great for taxpayers. For that reason, these transactions have been very popular for a number of years.