The Tax Cuts and Jobs Act of 2017 (TJCA) changed the tax landscape as we know it, and section 1031 like-kind exchanges were no exception.
Section 1031 Like-Kind Exchanges
In the typical course of a business, assets used in trade or business are bought and sold frequently. Whether this is to keep up with technological changes of the equipment needed to effectively run your business, to routinely upgrade work vehicles, or to purchase a new real estate property, the like-kind exchange could be used to defer the tax gain on these transactions until the asset received in said transaction is later sold. For decades, taxpayers were able to elect this treatment on most business property, as long as the property purchased had the same nature, character, or class, even if quality was not comparable. A prime example is a company vehicle that is continually traded in for a newer vehicle every few years. Rather than selling the vehicle, recognizing a gain on the sale, and then buying another vehicle, the owner could trade continuously and defer the gain until the vehicle is actually sold.
Change in Qualifying Property
Effective January 1, 2018, like-kind exchange treatment only applies to real property that is held for use in a trade or business or for investment. Real property, more commonly referred to as real estate, includes land and anything built on or attached to the land. Real property held primarily for sale (i.e. inventory) and real estate property located outside of the United States does not qualify for like-kind exchange treatment; this rule remains unchanged from prior tax law. Under new law, the prior tax-deferral benefit of gains no longer applies to the following personal and other property:
- Machinery
- Equipment
- Vehicles
- Artwork/Collectibles
- Patents/Other Intellectual Property
For industries that swap these assets as a regular part of business, this change creates great differences in the way sales and subsequent purchases of replacement property are recorded for tax purposes. Gains once deferred on a like-kind exchange will now have to be fully recognized in the tax year that the exchange occurred. Lawmakers felt that the ability to deduct the cost of these assets through either 100% bonus depreciation or section 179 depreciation provides enough benefit that like-kind exchanges should no longer be allowable for this type of property. Real estate exchanges, however, will still be able to enjoy this tax benefit.
Requirements for a Real Property Like-Kind Exchange
While the TCJA changed the property classifications that qualify for a Section 1031 exchange, the rules within the exchange remained consistent. Like-kind exchanges are still only applicable to business or investment property. If the property is personally used, such as a taxpayer’s primary home or vacation home, it does not qualify. For the exchange of real property to qualify in a like-kind exchange, certain qualifications must be met. Additional rules are as follows.
Property must have the same nature, character, or class.
A simple example of this rule would be the exchange of one apartment building for another apartment building or a vacant lot for another vacant lot. However, a real estate transaction would also be considered like-kind if that same apartment building was exchanged for a shopping mall, vacant lot, or office building. It is important to note that grade and quality of the property is not a factor in determining eligibility; improved property versus unimproved property would also be considered like-kind. These facts allow for a broad range of possibilities for those involved in the exchanging of real estate.
Timing and other Requirements
There are also two timing requirements for the Section 1031 exchange. If both are not met, then the entire gain will need to be reported and recognized in the year of the exchange. If a taxpayer desires to utilize the benefits of the like-kind exchange, proper tax planning should be done in advance to be sure that time and cost requirements are met.
The property that will be received in the exchange must be identified within 45 days after the sale of the property being given up by the entity, and the exchange must conclude within 180 days, or the due date of the income tax return including extension, whichever is earlier. The replacement property identified must be recorded in a signed written document and delivered to either the person obligated to transfer the replacement property or the qualified intermediary.
A qualified intermediary (QI) is a non-bias third party that facilitates the transactional requirements of a Section 1031 like-kind exchange. The QI cannot be your CPA, attorney, broker, or real estate agent, as they must be completely independent of the situation. This person is responsible for the following:
- Coordinating and preparing documentation concerning the property involved in the exchange.
- Handling depositing of the funds from the sale during the 45-day identification period.
- Holding all written information regarding potential replacement properties.
- Transferring funds for purchasing of the identified property.
- Acquiring the replacement property in their name and then transferring that title by deed to the taxpayer.
- Creating complete accounting of the 1031 exchange for the taxpayers’ records to assist their attorney and CPA with any additional reporting.
- Submitting a 1099 for any growth proceeds.
The best way to locate a QI is through references from others in your industry, your tax advisor, or your attorney. Escrow officers are another reference point available to help you find the best qualified intermediary for you. It is of great importance to make sure whoever you choose for this role has proper insurance to protect you and your business from any potential errors, omissions, fraud, or negligence.
Cost Requirements and Basis Tracking
The market value of the replacement property to be purchased through a like-kind exchange must be of equal or greater value compared to the property you are relinquishing. If this condition is not met, the gain will no longer be eligible for deferral.
If the property your business desires to exchange happens to be of lesser value, boot (cash) can be given to the seller to increase the value of the transaction and carry out the like-kind exchange. The boot received in the initial Section 1031 exchange will create a gain that is taxable up to the amount of the boot. Any gain remaining after this step will still be tax-deferred. Another issue to consider is the basis of the replacement property. Correctly calculating and tracking basis of the replacement property is very important, because the tax owed on the disposition of the property is not permanently avoided; it is only deferred until final sale of the replacement property occurs. The basis of the replacement property will take on the basis of the property given up, plus or minus certain adjustments. Any costs incurred by the taxpayer to improve or alter the property, as well as any boot paid, will increase the basis of the received property. Additionally, basis will decrease by any boot the taxpayer received or any loss recognized on the exchange.
Related Parties and Like-Kind Exchanges
A related party is defined as immediate family members such as brothers, sisters, spouses, parents, and ancestors. Section 1031 exchanges between related parties are allowed. However, if either party sells the property received in the original like-kind transaction during the two years after the exchange, the gain that was previously deferred must be recognized as of the date of the later disposition. When the like-kind exchange occurs between related parties, this must be disclosed on the proper tax forms in the year of the exchange.
Final Thoughts
While the Tax Cuts and Jobs Act of 2017 removed the ability to recognize a like-kind exchange on property that is not classified as real property, the rules that surround a qualifying exchange remain constant. If you or your business are considering selling an old property to purchase a new one, contact your LBMC tax advisor to discuss whether the transaction will qualify for the like-kind exchange. These exchanges can be very complex, and ensuring the rules are followed is essential in effectively deferring your tax gain.
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LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.