Like-Kind Exchanges or 1031 transactions allow taxpayers to dispose of property and defer the gain or loss if the property is exchanged for like kind property.
In English, what this means is that if you were to trade real estate, then you would have to exchange it for real estate, an automobile for an automobile, etc. Keep in mind both the property given and the property received must be used for business or investment purposes.
Like-kind exchange rules may apply to many types of property. The most common questions revolve around real estate and therefore this will be my focus.
Like-kind exchange rules generally discuss exchanging one piece of property for another simultaneously. These rules certainly can apply to real estate; however it is very difficult to find two individuals willing to exchange properties. The solution to this problem can be found in a delayed exchange.
In a delayed exchange a taxpayer may sell a piece of business or investment property and purchase, at a later date, replacement property and still qualify under the like-kind exchange rules. While this can obviously be a very attractive way to sell property that has appreciated in value, great care must be taken as the rules are complex and any mistake will disqualify the transaction and render it immediately taxable.
The major requirements of a delayed exchange are as follows:
- Replacement property must be identified within 45 days of the sale of the property relinquished.
- The taxpayer must close on the replacement property on the earlier of the 180th day after the sale of the property relinquished or the due date of the taxpayer’s income tax return (including extensions).
- The taxpayer cannot receive the money from the sale of the relinquished property. In most cases the proceeds of the first sale are held by a “qualified intermediary” until they are needed to close on the replacement property.
- The purchase price of the replacement property must be at least as much as the sales price of the property relinquished or a portion of the gain will not be tax deferred.
Once again, if any of the above provisions are violated, then the transaction will become immediately taxable.
It is important to keep in mind that although the rules for what qualifies as like-kind real estate are fairly liberal, neither personal residences nor vacation homes will qualify. These types of properties may be converted to business or investment use; however this usually requires significant time (approximately 2 years).
It is also important to remember that like-kind exchanges defer taxes and do not eliminate them. If the taxpayer later sells the replacement property gain or loss would be recognized unless the taxpayer enters in to another like-kind exchange.
In addition, there are a variety of other factors that may come in to play. This article is meant to give a basic overview of the law.
The rules of like-kind exchanges are complex and stringent, however if followed correctly can be well worth the time and effort. It is, of course, vital that any taxpayer seek the advice of tax professionals familiar with such transactions.