What is an IRC Section 1031 Exchange?
An IRC Sec. 1031 like-kind exchange is an effective method for investors to defer taxable income from the sale of investment property by reinvesting the proceeds into like-kind property of equal or greater value (i.e., avoid gain recognition on appreciated real property). Essentially, the exchange allows an investor to swap one real estate investment property for another within a certain period of time and, assuming IRS rules are met, permits them to avoid gain recognition and, defer income taxes on the gain on the sale of the relinquished real estate investment property.
Functionally, an investor participating in such a transaction transfers their property to be relinquished into an escrow account, managed by and unrelated third-party (“qualified intermediary”), who consummates a sale of the property to be relinquished and transfers the sales proceeds to acquire identified replacement property (of equal or greater value).
The exchange allows an investor to:
- Defer income taxes on the sale of real estate.
- Provide maximum flexibility to reinvest in new real estate.
- Flexibility to reduce debt on future real estate acquisitions.
Generally, an investor must identify the replacement property within 45 days of the sale of the relinquished property and complete the exchange within 180 days.
More Information on IRC Section 1031 Exchanges
As described in the foregoing summary, investors can dispose of appreciated real property without being taxed on the gain by exchanging it rather than selling it outright thereby, deferring taxes on the gain through the “like-kind” exchange rules.
A like-kind exchange is any exchange (1) of real property “held for investment” or “held for productive use” in your trade or business (referred to as the “relinquished property”) for (2) like-kind investment real property or trade or business real property (“replacement property”).
For these purposes, “like-kind” is very broadly defined, and most real property is considered to be like-kind with other real property. However, neither the “relinquished property” nor the “replacement property” can be real property “held primarily for sale”. If you are unsure whether the property involved in your exchange is eligible for a tax-free like-kind exchange, please reach out and we can discuss the matter.
Assuming the exchange qualifies, here’s how the tax rules work:
If it’s a straight asset-for-asset exchange, you will not have to recognize any gain from the exchange. You will take the same “basis” (your cost for tax purposes) in the replacement property that you had in the relinquished property. Even if you do not have to recognize any gain on the exchange, you still must report the exchange on Form 8824.
Frequently, however, the properties are not equal in value, so some cash or other (non-like-kind) property is tossed into the deal. This cash or other property is known as “boot.” If boot is involved, you will have to recognize your gain, but only up to the amount of boot you receive in the exchange. In these situations, the basis you get in the like-kind replacement property you receive is equal to the basis you had in the relinquished property you gave up reduced by the amount of boot you received but increased by the amount of any gain recognized.
Example. Jennifer exchanges land (investment property) with a basis of $100,000 for a building (investment property) valued at $120,000 plus $15,000 in cash. Jennifer’s realized gain on the exchange is $35,000: she received $135,000 in value for an asset with a basis of $100,000. However, since it’s a like -kind exchange, she only must recognize $15,000 of her gain: the amount of cash (boot) she received. Jennifer’s basis in her new building (the replacement property) will be $100,000: her original basis in the relinquished property she gave up ($100,000) plus the $15,000 gain recognized, minus the $15,000 boot received.
Note that no matter how much boot is received, you will never recognize more than your actual (“realized”) gain on the exchange.
If the property you are exchanging is subject to debt from which you are being relieved, the amount of the debt is treated as boot. The theory is that if someone takes over your debt, it’s equivalent to their giving you cash. Of course, if the replacement property is also subject to debt, then you are only treated as receiving boot to the extent of your “net debt relief” (the amount by which the debt you become free of exceeds the debt you pick up).
Please note, a like-kind exchange can be wide in its scope – the following listing represents a short description of some of the different types of exchanges that can be performed for investors:
Forward Exchange also referred to as a Delayed Exchange, involves the sale of one or more pieces of property, the proceeds of which are held by a Qualified Intermediary, and the Seller identifies one or more replacement property (ies) within 45 days and completes the purchase of the replacement property (ies) within 180 days after the initial sale.
Reverse Exchange involves the initial purchase of one or more replacement properties, held in the name of the Qualified Intermediary, for the benefit of the customer followed by the identification of one or more properties to be sold within 45 days and the sale of one or more properties within 180 days.
Build to Suit Exchange involves the acquisition and construction of property within the applicable 180-day period.
Improvement Exchange involves the use of the funds in the account balance to construct improvements on the property to be acquired.
Parking Arrangement Exchange comes into play when it is not possible to carry out the transaction within the typical 180-day period, such as a major construction project, or unique properties. This type of transaction is complex and deals with those situations when the amount of taxable gain may be very large.
Like-kind exchanges are an excellent tax-deferred way to dispose of investment or trade or business assets. Templeton partners with IRC Section 1031 specialists to provide 1031 Exchange services to our clients; assisting in the buying and selling of business assets by deferring income taxes, increasing their cash flow and promoting growth and profitability. We partner with experienced Board-Certified tax attorneys & exchange professionals who will:
- Identify and implement the best tax strategy to maximize the cost savings utilizing over 26 years of extensive tax lawyer expertise;
- Review any and all documents in connection with the transaction to avoid errors or mistakes in connection with the exchange; and
- Provide an audit ready package with tax forms, documentation and a tax opinion, if requested, that protects the client from IRS penalties and interest thereon.
We offer branded exchange services to meet our client’s needs. If you have additional questions or would like to discuss the topic further, please reach out.