1031 LIKE-KIND EXCHANGES: A Way to Defer Liability for Capital Gains Taxes In a Real Estate Transaction

Generally speaking, when the owner of real property sells or otherwise disposes of that property and makes a profit, he or she will be liable for capital gains taxes on those capital gains.  The amount of capital gains to be taxed is calculated as the amount realized on the transfer minus the owner’s “basis” in the property (with the “basis” being the original cost of the property to the owner, adjusted for various factors set out in the Internal Revenue Code).

Section 1031 of the Internal Revenue Code (“Section 1031”) affords owners of appreciated business or investment real estate property the ability to leverage 100% of the property’s value by deferring tax liability for the capital gains at the time the property is disposed of – so long as another like-kind property is acquired per the requirements set forth in Section 1031.

It’s important to keep the following in mind regarding a Section 1031 “like-kind exchange”.   In a Section 1031 transaction, the tax on the gain from the sale is only deferred to a later date, not eliminated entirely.  Furthermore, after the Tax Cuts and Jobs Act of 2017 became effective on January 1, 2018, the tax-deferral benefits of Section 1031 are limited to exchanges of real estate property held for use in a trade or business, or for investment, and are no longer available for the exchange of personal property such as stock or corporate membership interests.  Finally, the availability of Section 1031 is dependent on satisfying all of its specific requirements (discussed further below).

Nonetheless, Section 1031 remains a potent mechanism for deferring taxes on capital gains. There is no limit on how many times or how frequently an owner can use Section 1031 to roll over gain from one given property to another property and then another.  Although there may be a profit on each transaction, payment of capital gains tax is deferred until the owner sells the property in a non-Section 1031 transaction at a later time.  In some instances, there will be no tax at all when the owner’s heirs inherit the property at the time of his death, because they will receive a stepped-up basis equal to the property’s fair market value as of the date of the owner’s death (effectively making any appreciation of the property during the decedent’s life tax-free).  When the property is subsequently sold by the heirs, they will pay capital gains tax on only the increase in value over the stepped-up basis.

I.  What Property Qualifies as Like-Kind Property?

Both the transferred property (“Relinquished Property”) and the property received in exchange (“Replacement Property”) must be held for use in a trade or business, or for investment, and must be similar enough to qualify as “like-kind.”  The meaning of “like-kind” property is very broad and only requires that the properties be of the same nature, class, or character.  Dissimilarities in grade or quality between the two properties does not matter.  Virtually all real estate is like-kind to other real estate. For example, an office building will be like-kind to farm land or other unimproved property to be held for investment.

However, the exchanged properties must be of similar value for the like-kind exchange to defer all taxes.  If there is cash or other non-qualifying property left over after the Replacement Property is acquired (so-called “boot”), the owner will owe taxes on the boot.  Furthermore, debt on both the Relinquished Property and the Replacement Property must also be considered when evaluating the exchange.  If the purchase price plus any new loans on the Replacement Property is less than that of the sale price of the Relinquished Property, gain will be recognized to the extent of the difference.  Thus, for example, if an owner (the “Exchangor”) sells a Relinquished Property for a sales price of $1,000,000 that carries a $600,000 mortgage, the purchase price of the Replacement Property would need to be at least $1,000,000 with $600,000 or more in loans in order to maximize the benefits of Section 1031.

II.  Who Qualifies for the Benefits of Section 1031?

Individuals, C corporations, S corporations, partnerships, limited liability companies, trusts, and any other tax-paying entity may set up an exchange under Section 1031.  It is important to note that the name of the Exchangor on its tax return and its deed to the Relinquished Property must be the same as the name on the tax return of the acquiring entity and in the deed to the Replacement Property.  However, there is an exception for single member limited liability companies.  In that case, the Relinquished Property may be sold by the entity, but title to the Replacement Property may be in the name of the single member of the limited liability company because the single member entity is disregarded for tax purposes.

III.  What is the Process for Conducting a 1031 Exchange?

To qualify for Section 1031 treatment, the exchange must be distinguished from a situation where an owner sells a property and then uses the cash proceeds to buy another property.  Section 1031 offers four types of exchanges to choose from (to be discussed in more detail below).  The simplest form involves the direct exchange of one property for another on the same day.  The exchange must occur simultaneously and any delay, such as wiring funds to an escrow company, could result in disqualification of the exchange.  However, it is unlikely that an Exchangor will find a buyer for the Relinquished Property and a seller of a Replacement Property at the same time.  Therefore, most exchanges are deferred three-party exchanges that require the use of a “qualified intermediary” to successfully complete a Section 1031 tax deferred exchange.

A.  Qualified Intermediaries. There are many companies that can be selected to act as a qualified intermediary to facilitate a Section 1031 exchange.  However, the qualified intermediary may not be the taxpayer or a disqualified person (i.e., anyone who is related to the taxpayer, or who has had a financial relationship with the taxpayer).

The qualified intermediary will enter into a written exchange agreement with the Exchangor under which the intermediary will agree to transfer the Relinquished Property and acquire the Replacement Property.  The exchange agreement must expressly limit the Exchangor’s rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property received in the sale of the Replacement Property.  If the Exchangor takes any control of cash or other proceeds before the exchange is completed, it may disqualify the entire transaction from tax deferred treatment.  The use of an experienced qualified intermediary can significantly reduce the complexity of an exchange by assuring the proper execution and processing of required documentation. However, since the qualified intermediary industry is not regulated, the careful selection of the qualified intermediary is essential to ensure the highest level of expertise and security for funds.

B.  Time Limits. There are certain time limits that must be met for an exchange to qualify for Section 1031 tax deferred treatment.  First, the Exchangor of the Relinquished Property must clearly identify possible Replacement Properties to the qualified intermediary in writing within 45 days of the sale of the Relinquished Property.  Second, the Replacement Property must be purchased and the exchange completed no later than 180 days after such sale.  More than one property may be identified as a possible Replacement Property and it is not necessary to purchase all the potential Replacement Properties identified, but at least one must be purchased within this timeframe to qualify as a Section 1031 exchange.

  1. Types of Deferred Exchanges: Delayed, Reverse, and Construction Exchanges.  As discussed above, a “simple” Section 1031 exchange involves a same-day sale and purchase of two like-kind real properties.  Deferred exchanges are more common and require that the sale of a Relinquished Property and the purchase of a Replacement Property be dependent parts of an integrated transaction.  There are three types of deferred exchanges, which are often referred to as delayed, reverse, and construction exchanges.

a.  In a delayed exchange, which is the most common form of deferred exchange, the Exchangor must (i) market, (ii) find a buyer for, and (iii) enter into a sales agreement for, the Relinquished Property.

  • Once this has occurred, the Exchangor enters into a written exchange agreement with a qualified intermediary and assigns the existing sales agreement to the qualified intermediary prior to the closing of the sale.
  • Once the closing of the sale occurs, the qualified intermediary receives the proceeds (the Exchangor cannot receive the proceeds without disqualifying the exchange).
  • After the sale, the proceeds must be held in a trust by the qualified intermediary during which time the proceeds must be used for the purchase of a Replacement Property for the Exchangor.
  • The Replacement Property must be specifically identified by the Exchangor to the qualified intermediary within 45 days of the Relinquished Property’s sale. The property identification must be in writing, must describe the Replacement Property with a legal description, street address, or other distinguishable name, and must be delivered to the qualified intermediary or the seller of the Replacement Property.  Identification of the Replacement Property to the Exchangor’s real estate agent, CPA, or lawyer is not sufficient.
  • The Replacement Property must be acquired by the Exchangor, and the exchange completed within 180 days after the Relinquished Property was sold or by the due date (including any extensions) of the income tax return of the Exchangor for the year in which the Relinquished Property was sold.

b.  In a reverse or forward exchange, the Replacement Property selected by the Exchangor will be acquired first and “parked” with the qualified intermediary until it is transferred in a simultaneous exchange for the Relinquished Property. The qualified intermediary will obtain the funds to purchase the Replacement Property by borrowing it from the Exchangor or a lender.

  • The qualified intermediary can hold the parked property for no more than 180 days from the date of purchase during which time the Relinquished Property must be identified, sold, and the Replacement Property transferred to the Exchangor.
  • Such identification must occur within 45 days after the purchase of the Replacement Property.
  • After the initial 45 day identification period, the Exchangor has an additional 135 days to complete the sale of the Relinquished Property through the qualified intermediary.
  • The failure to identify the Relinquished Property within such 45 days and to close on its sale during the 180 day period will result in the exchange failing to qualify for Section 1031 tax deferred treatment.
  • Proceeds from the sale of the Relinquished Property will go to the qualified intermediary and will be used to repay loans incurred to purchase the Replacement Property.

c.  The construction/improvement exchanges are the most complex of the deferred exchanges but allow the Exchangor to make improvements to the Replacement Property before it is transferred to the Exchangor using the funds received from the sale of the Relinquished Property.

  • In this type of exchange, the Exchangor and the qualified intermediary will, in addition to the exchange accommodation agreement, enter into a construction management agreement pursuant to which the Exchangor is granted the right to make improvements to the Replacement Property on behalf of the qualified intermediary, and is made fully responsible for the supervision and performance of all of the work and the payment of all expenses related to the design and construction of such improvements.
  • If there will be any third-party occupancy of the Replacement Property prior to the date that ownership will be transferred to the Exchangor, the parties will also enter into a lease (ending no later than the 180th day) under which the third-party may occupy the Replacement Property during construction of the improvements.
  • To qualify the construction exchange for the benefits of Section 1031, all of the funds from the sale of the Relinquished Property must be used to pay for the Replacement Property and improvements, and such improvements and the exchange must be completed within 180 days of the Relinquished Property’s sale.
  • The Exchangor must receive substantially the same Replacement Property as it identified to the qualified intermediary, and the improved Replacement Property must be of equal or greater value than the Relinquished Property in order to defer 100% of the tax.

IV.  How is the Basis of the Replacement Property Calculated?

As noted previously, in a Section 1031 transaction the tax on the gain from the sale is merely deferred, not eliminated.  Therefore, the basis of the Replacement Property must be calculated to preserve the deferred gain for taxation in the future.  The basis of the Replacement Property is the basis of the Relinquished Property, decreased by the amount of any money and non-like-kind property received from the sale of the Relinquished Property, and increased by the amount of any gain (or decreased by the amount of any loss) recognized in the exchange.  If boot is also received in the exchange transaction, the basis of the Relinquished Property must be allocated between the Replacement Property and the boot, assigning to the boot an amount equal to its fair market value on the date of the exchange.

It is clear that a Section 1031 exchange provides the Exchangor with a significant tax deferral benefit.  However, there are two potential downsides to the exchange.  First, in most instances, the basis for depreciation of the Replacement Property will be less than the value of the Relinquished Property at the time of exchange, and second, when the Replacement Property is sold, even at a loss, capital gains tax will be owed on all amounts received in excess of the basis of the Replacement Property.  For example, if the Relinquished Property had a basis of $1,000,000 and a value of $2,000,000 at the time of exchange, the basis of the Replacement Property for depreciation will only be $1,000,000 not $2,000,000, thus preserving the $1,000,000 in deferred capital gain.  If the Replacement Property is later sold for $1,800,000, there will be capital gains taxes owed on $1,000,000, even though the Replacement Property was sold for $200,000 less than the value of the Relinquished Property.  Any decision by a property owner to utilize the Section 1031 process should be discussed thoroughly with a qualified tax consultant.

If you have any questions regarding Section 1031 exchanges or other commercial real estate matters, contact Chip Gerry at CGerry@fh2.com  or (770) 399-9500 for more guidance.

Chip Gerry
About the author:
Chip Gerry, Partner, Practice Leader - Commercial Real Estate
Chip’s practice offers clients a comprehensive understanding of commercial real estate and corporate law, in addition to specializing in federal and state telecommunications law. His goal in providing representation is to facilitate the achievement of his client’s objectives, while protecting their interests in a cost effective and efficient manner. For more information about Chip, Click Here.

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