All gains you earn from selling properties are taxable, and as such, you must report them to the IRS. Section 1031 of the IRC allows taxpayers to delay paying taxes for such gains if they use the funds to acquire a similar property.
As a result, you won’t have to pay taxes immediately if the transaction meets the requirements of like-kind exchanges defined in Section 1031.
That said, it’s essential to understand that the gains you obtain through a like-kind exchange aren’t tax-free. However, it’s possible to delay paying taxes indefinitely by continuing to invest in property.
We’ll walk you through Section 1031 and give you the information you’ll need to determine if you qualify for tax deferral under this section of the IRC.
Table of Contents
An Overview of The Section 1031 of The IRC
All US taxpayers who own an investment or business property can benefit from a like-kind exchange.
The C and S corporations, trusts, LLCs, limited or general partnerships, and individuals can participate in a like-kind exchange if the property they’re selling and acquiring meets the requirements laid out in Section 1031.
Hence, a simple transaction in which a taxpayer sells a property and acquires another doesn’t constitute a like-kind exchange. That’s why you won’t be eligible for a tax deferral under Section 1031 if you sell your primary residence.
The exchange can also include cash, property that doesn’t qualify as like-kind, or other liabilities, which means that the same transaction can contain recognized and deferred gains.
Like-Kind Exchange Property Types
According to Section 1031, personal and real property can meet the exchange requirements. However, the section provides strict rules regarding exchanges involving personal property and stipulates that it can’t be like-kind to real property under any circumstances.
Both properties in a like-kind exchange must be of the same ‘character, class, or nature,’ while their quality is of no consequence. Section 1031 rules indicate that only properties used for investment or business purposes qualify for tax deferrals.
The section also defines property types that cannot participate in like-kind exchanges:
- Certificates of trust
- Debt or securities
- Bonds, notes, and stocks
- Inventory in a trade
- Partnership interests
Taxpayers face time restrictions when attempting to qualify for a like-kind exchange. You’ll have 45 days to find a replacement property from the moment you sell your property.
A signed document declaring your intent to invest in a replacement property must be delivered to its owner or seller within this time frame. The exchange must be completed 180 days after the sale of your property or at the filing deadline of the current tax year.
Receiving cash or other types of gain before the exchange is finalized makes all profits taxable.
The Structure of a Section 1031 Exchange
Sellers and buyers must enter an exchange agreement that guarantees the buyer can hold the seller’s proceeds until the sale is finalized and prevents the seller from receiving proceeds.
A simultaneous exchange is the most common type of like-kind exchange. It involves swapping relinquished and replacement properties without delay, which limits the flexibility of both parties.
- Deferred or Delayed Exchange – Sellers of a relinquished property have 45 days to identify the replacement property and 180 days to complete the transaction.
- Construction Exchange (Built-to Suit) – Section 1031 allows taxpayers to trade property for a vacant lot and use the untaxed gains to build a new property.
- Reversed Exchange – Rather than selling a relinquished property first, a reversed exchange involves acquiring a replacement property before selling a relinquished property.
Properties must be similar in their function to qualify for a like-kind exchange, which is why you cannot offer a rental house as relinquished property and receive a vacation home as a replacement.
Like-kind rules for personal property such as artworks, vehicles, or intellectual property are even stricter, so a truck cannot be like-kind to a racing car. Gains of 1031 exchanges become taxable unless kept in an escrow by a qualified intermediary.
Even though capital gain taxes don’t apply to like-kind exchanges, sellers may have to pay taxes for their properties if they make depreciation deductions.
Characteristics of Like-Kind Exchange Property
The IRS offers vague instructions regarding the characteristics of properties that can participate in 1031 exchanges. Still, this section of the IRC states the property ‘must be held for investment or used for trade or business purposes.’
Consequently, an unrented property doesn’t qualify for like-kind exchanges. On the other hand, vacant land can’t be rented, and as such, it is regarded as ‘held for investment,’ which makes it suitable for tax deferral under Section 1031.
Real property qualifies for like-kind exchanges as long as it is used for commercial purposes. Consequently, rental properties and office buildings are considered like-kind even though their functions differ.
Coops and leaseholds can be like-kind under specific conditions. Some jurisdictions recognize coops as real estate and allow exchanges with leaseholds with less than thirty years of the term.
Gains generated through like-kind exchanges are not tax-free. You’ll carry the tax basis from the property you relinquish to the replacement property.
Consequently, the deferred tax will be recognized if you decide to sell the replacement property rather than exchange it in a like-kind transaction.
Section 1031(f) defines exchanges with related parties and stipulates that the exchange can only be valid if a related party keeps the relinquished property for more than two years.
What is a Qualified Intermediary?
A qualified intermediary is a company or a person who completes the sales of a relinquished property, obtains a replacement property, and transfers the deed to the seller. Please note that sellers cannot act as qualified intermediaries.
The primary role of a qualified intermediary is to hold the funds generated by the transaction in an escrow during the identification period and transfer them to the seller after a replacement property is identified.
Reporting Like-Kind Exchange to The IRS
Taxpayers who use Section 1031 to exchange property must report the transaction to the IRS on Form 8824. The document should be filed with the rest of the tax return documents in the tax year in which the transaction occurred.
This form gathers information about relinquished and replacement properties, their value, and assumed or relieved liabilities. It also aims to establish a relationship between the buyer and the seller and determine the realized gain.
You may face penalties and interests if you fail to file this document with a tax return or follow like-kind exchange rules. Moreover, you’ll have to pay capital gain taxes if the IRS disallows the exchange.
Frequently Asked Questions
This section of the IRC states that property outside of the United States cannot be considered like-kind to the property within the United States.
Completing a like-kind exchange without a qualified intermediary is against IRS rules and results in the disallowance of the transaction.
Opting for a 1031 exchange will reduce your tax burden by enabling you to postpone paying capital gain taxes. Consequently, completing a like-kind exchange can be a better option than selling a property if you don’t want to pay capital gain tax right away.
All gains you obtain through like-kind transactions must be reinvested in a replacement property. Partial 1031 exchanges allow taxpayers to keep a portion of the profit, although the amount they gain is taxable.
Creating Investment Opportunities With Like-Kind Exchanges
Section 1031 exchanges are commonly utilized to reset depreciation on a rental property, consolidate multiple properties into one, or obtain replacement properties with high return potential.
Even though this section of the IRC defines like-kind property loosely, you must be familiar with all Section 1031 exchange rules to avoid increasing your tax liability.
Hence, you must know which property types meet the like-kind requirements to make the most of this tax deferral exception. Finding a reliable qualified intermediary is the first step you’ll have to take if you decide to invest in real estate through like-kind property exchanges.
Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
