Article by: Jeff Skolnick, CPA, M.S. Taxation
Like-Kind Exchanges or 1031 transactions allow taxpayers to dispose of property and defer the gain 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 identification must be in a written document signed by the taxpayer and delivered to the seller of the replacement property or anyone who is not a disqualified person. It is usually given to the qualified intermediary.
- 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. While there is no requirement to use a qualified intermediary, the taxpayer is not allowed to use anyone who has had a financial relationship with the taxpayer in the last two years. That rules out the current attorney, accountant, investment banker, broker or real estate agent. Each of these individuals is considered to be a disqualified person. Qualified intermediaries are used to these transactions and in my opinion worth the money to make sure the transaction is completed properly. I have read articles detailing that there is a lack of regulation of Qualified Intermediaries so make sure you do your research and find one that is reputable and bonded.
- 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 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). Again, keep in mind properties must be identified within 45 days and generally closed on within 180 days. This can be the most difficult part of the transaction.
It is also important to remember that like-kind exchanges defer taxes and do not eliminate them. In other words the gain you defer will reduce the cost basis of the property you purchase and the gain will be realized upon the sale of the replacement property 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. The rules, however, if not followed 100% will destroy the transaction and the deferral will be disallowed and the transaction will become immediately taxable. It is, of course, vital that any taxpayer seek the advice of tax professionals familiar with such transactions.
You can visit me check this out on my latest podcast at: https://anchor.fm/jeffrey-skolnick/episodes/Episode-13-Defer-taxes-on-real-estate-sales-e3ufca
