Most individuals have heard the
terminology "like kind exchange" or 1031 exchange. These two phrases are
used interchangeably. Whether someone calls the transaction a "like kind
exchange" or a 1031 exchange, this form of transaction can be very beneficial
to a taxpayer. Therefore, it is important to understand 1031 exchanges.
The name 1031 exchange comes from the Internal Revenue Code Section which
allows for like kind exchanges and the deferral of gains. 1031 of the Internal
Revenue Code is titled "Exchange of property held for productive use or investment."
So, what exactly is a 1031 exchange? In the simplest terms a 1031 exchange is a
transaction in which one investment is exchanged for another investment.
The most attractive part of a 1031 exchange is the deferral of the gain on the
transaction. However, there are many requirements to meet for a transaction to
qualify as a 1031 exchange.
The first requirement is the property being exchanged must be held for
"productive use in a trade or business or for investment." For example,
if a taxpayer owned a vacation property used for personal use, the vacation
property would not qualify for a like kind exchange. The property must be used for business. Therefore, a rental
property would qualify since it is used for a business/investment
purpose. Therefore, it is important to understand how the property in
question is used.
The next requirement for a successful like kind exchange is the property must
be exchanged for like kind property. This does not mean if the property is an
apartment building used as a rental the new property has to be an apartment
building used as a rental property. The
properties involved in the exchange must be of the same nature or character.
Therefore, real property must be exchanged for other real property. Likewise,
personal property must be exchanged for other personal property.
Generally, it is fairly easy to exchange personal property and for it to meet
the requirements of 1031. For example, a taxpayer has a piece of equipment he
would like to upgrade. The taxpayer is able to take the piece of equipment to
an equipment dealer and trade in the piece of property for another piece of
property. The taxpayer will most likely pay additional cash or take out a loan
for the difference between the value of the property received and the property
given up since he is upgrading the equipment. However, if the value of the
property received is less than the value of the property given up and the
taxpayer receives cash for the difference a gain will be recognized by the
Anytime a taxpayer receives cash in a 1031
transaction, he is required to recognize a gain. Also, if the taxpayer receives unlike property, gain will be recognized.
A common term used when dealing 1031 exchanges is "boot". Boot means cash or
any non-like-kind property. Therefore, when boot is received by the taxpayer,
he will recognize a gain.
1031 exchanges become more complicated when the taxpayer is not able to easily
trade or swap one piece of property for another. A taxpayer may decide he would
like to exchange a piece of farm land for another piece of farm land. However,
he is unable to find anyone who would be interested in completing an exchange
with him. He has found someone interested in purchasing the land he currently
owns. It is still possible for the taxpayer to complete a deferred exchange
The Internal Revenue Code provides guidelines on how a transaction or series of
transactions will qualify as a like kind exchange under 1031. If the taxpayer
has a purchaser for his farm land, the first consideration he must take into
account is the fact that if he receives cash then a gain is recognized. Furthermore,
if the taxpayer receives the
proceeds for the farm land he has given up in the transaction, the transaction
no longer qualifies as a 1031 exchange. In fact, the transaction is now
considered a sale and the entire gain must be recognized by the taxpayer.
Therefore, it is important that the taxpayer does not receive money from the
transfer of the property.
1031(k)-1(g) provides safe harbors that "the use of which will result in a
determination that the taxpayer is not in actual or constructive receipt of
money or other property for purposes of section 1031." Therefore, it is
critical the taxpayer meets the safe harbors in order for the transaction to
qualify as a like kind exchange und 1031. One of the common used safe harbors
is hiring a qualified intermediary. The qualified intermediary has many duties.
One of the duties is holding the cash received on the transfer of the
taxpayer's original property until the replacement property is transferred. This
takes the question of whether or not the taxpayer actually or constructively
received money or other property out of the equation.
1031 also provides specific timing requirements for like kind exchanges to
qualify. The taxpayer must identify the
like kind property to be received within 45 days of transferring the original
property. The identified property must be received the earlier of 180 days
after transferring the original property or the due date including extensions
of the taxpayer's federal income tax return. The taxpayer and his
advisors must pay careful attention to the timing of the identification and
transfer of the replacement property. Missing one of these deadlines by
even one day causes the transactions to not qualify as a 1031 exchange. Therefore,
instead of having a tax deferred exchange the taxpayer now has a gain to
recognize and tax to pay on the gain.
Another option available to the taxpayer is a reverse exchange. A
reverse exchange occurs when the taxpayer finds a replacement property and
takes title prior to relinquishing the original property. The IRS has
issued Revenue Procedures 2000-37 and 2004-51 for guidance on reverse exchanges
including safe harbor requirements which allow reverse exchanges to be treated
as like kind exchanges.
Like-kind exchanges are reported to the IRS on Form 8824 and attached to the
taxpayer's income tax return. On Form 8824 the taxpayer includes descriptions
of the property given up and received, dates of acquisition, transfer,
identification and receipt of property, related party exchange information, and
calculations of realized gain or loss, recognized gain, deferred gain or loss
and basis of like-kind property received.
Benefits for Taxpayer
A like-kind exchange has many benefits for a taxpayer. The first has already
been mentioned, which is deferral of gain recognition. This of course also
defers the payment of tax on the transaction. The gain will be recognized when
the replacement property is sold or the taxpayer could engage in another
like-kind exchange and defer the gain further. There is even the possibility of
the gain not being recognized at all. If the taxpayer passes away and the
property is part of his estate, the property will qualify for a step up in
basis and pass to the heirs with the fair market value at the taxpayer's date
of death as the heirs' basis in the property.
The deferral of taxes does provide an additional benefit. It allows the
taxpayer to have more equity in the new property. Instead of paying the tax on
the gain and reducing what is left over to invest in new property the money
that would be used for taxes remains as part of the investment.
There are many requirements to meet in order to have a successful like kind
exchange. It is important to know the requirements of 1031 of the
Internal Revenue Code. Imagine a taxpayer planning on a successful 1031
exchange occurring; yet, the transaction does not qualify because one of the
requirements was not met. Instead, he would recognize the gain on the
transaction and pay taxes related to the gain on the transaction. Most likely,
this taxpayer would be disappointed or even angry that he did not receive the
benefits of deferring the gain on the transaction. Therefore, it is important
to know the requirements to assist a client through the 1031 process.
Use the following checklist to determine if a 1031 exchange would be ideal for
a particular situation. If any of the
questions are "No" then an exchange is not a viable option.
the individual own property he would be interested in disposing of or
the property used for a business purpose?
the individual wish to continue in a trade or business?
the individual be interested in owning a different property of the same
nature or character?
the individual be interested in utilizing the different property in a trade
individual does not need cash from the sale of his property?
Questions and Contact
you have any questions, please contact Randy
Dickhut, Senior Vice President of Real Estate Operations, at (402) 496-3276.