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No Nonsense Straight Talk about Like-Kind (Section 1031) Exchanges
By Shannon L. Bollin, CPA, MST
With the recent increase in real estate values we have witnessed in this country over the last 10 years, it is little wonder that the popularity of well-known Internal Revenue Code Section 1031 has also increased almost on the same par as real estate values. To those new to this tax deferral concept, I wanted to provide you a sort of crash course in section 1031 basics.
The Basics. Internal Revenue Code Section 1031 permits the deferral of capital gains taxes on the sale of property held for investment or productive use in a trade or business if the property received is of a “like-kind” (and hence the colloquial name given to this code section as “like-kind exchanges”) and is held either for productive use in a business or for investment. Section 1031 permits the deferral of federal capital gains taxes of 15%, depreciation recapture of 25% and (in most cases) state taxes.
What is the effect of this Code Section? Generally, if you exchange business or investment property solely for business or investment property of a like-kind, section 1031 provides that no gain or loss is recognized. If, however, as part of the exchange, you also receive other (not like-kind) property or money in addition to the like-kind property, you must recognize some gain. The recognized gain, however, is limited to the amount of the cash and the fair market value of the other property received. A loss from a similar exchange (where some like-kind property plus some property that is not like-kind is received in the exchange) may not be deducted.
What does “like-kind” mean? Properties are of like-kind if they are of the same nature or character, even if they differ in grade or quality. Personal properties, such as tractors or machinery used in your trade or business, of a like class are like-kind properties. Personal property used predominantly in the United States, however, and personal property used predominantly outside the United States are not like-kind properties. Most exchanges of real properties qualify as like-kind exchanges. However, real property in the United States and real property outside the United States are not considered like-kind properties.
Exceptions and rules for personal residence with business use. These nonrecognition rules do not apply to stock in trade or other property held primarily for sale, and property used for personal purposes (i.e. home or family car). The disposition of property, however, that has been used concurrently or consecutively as a home and for business purposes may be eligible for both the sale of principal residence exclusion (of up to $500,000 for a married couple filing a joint return) and the deferral of gain on like-kind exchanges.
Special Rules. Special rules apply to like-kind exchanges made with related parties, either directly or indirectly. A related party includes your spouse, child, grandchild, parent, grandparent, brother, sister or a related corporation, S corporation, partnership, trust or estate.
In a like-kind exchange transaction one property does not have to be exchanged for another simultaneously. An exchange may qualify for like-kind treatment even if the replacement property is received after the relinquished property has been transferred as long as the taxpayer satisfies the specific identification and receipt requirements. After transferring the relinquished property, the taxpayer must identify replacement property within 45 days and must receive the replacement property within 180 days.
Example. Bill exchanged investment real estate, with a basis of $10,000, for other real estate (to be held for investment purposes) with a fair market value of $12,000 and $4,000 in cash. His realized gain of $6,000 (i.e. $16,000 value received minus $10,000 basis) is recognized only to the extent of the $4,000 cash he received. His basis for the real estate he received is $10,000 (i.e. $10,000 basis in old property, minus $4,000 cash received, plus $4,000 recognized gain).
If you would like to discuss this subject further, please contact Shannon Bollin (sbollin@pmn.com) or any member of our tax service team at (617) 426-9440.
Note: This article represents a general overview of or opinion on certain tax issues or developments and should not be relied upon without an independent, professional analysis of how any of these provisions may apply to a specific situation. We recommend you consult your professional tax advisor before taking any action based on anything in this article.
IRS CIRCULAR 230 NOTICE: In compliance with U.S. Treasury Circular 230 Regulations and any applicable state laws, we hereby notify you that any tax advice contained in the body of this document, or attachments thereto, was not intended or written to be used, and cannot be used, by the recipient or any other party for the purpose of (1) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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